The Pros and Cons of 529 Plans

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You may have heard of 529 plans, but should you use them? Before using any kind of education savings plan, you should understand the basics of how they work and evaluate the pros and cons.
529 plansIf you need to brush up on your knowledge, here’s basically how they work. A 529 plan is an education savings plan operated by a state and is named after Section 529 of the Internal Revenue Code.
The primary purpose of 529 plans is to save for college expenses. A secondary benefit of contributing to this type of education savings account is for deductions against state income taxes.
Although you don’t have to live in a state to invest in its 529 plan, most states offer tax incentives that only apply if you invest in your state’s plan. However, the location of the college does not matter. For example, a New York state resident can get all the tax-savings benefits of the New York 529 plan but the beneficiary of the plan can attend college in Massachusetts.
Similar to a Roth IRA, investments grow tax deferred and withdrawals are tax free if you use the account as intended, which in this case is for qualified education expenses.
529 plans have no income or age restrictions and most states allow contributions up to $300,000.

Types of 529 Plans

There are two basic types of 529 plans: savings plans and prepaid plans:

  • Savings plans are similar to a 401(k) with regard to investing contributions among a selection of mutual funds or similar investments, from which you may choose. The account value can go up or down, depending upon the type of investment(s) you select.
  • Prepaid 529 plans work as the name implies: They let you prepay all or a portion of college costs.

Pros and Cons of 529 Plans

529 plans can be a great way to save for college but they’re not for everyone. Here are some of the primary advantages of 529 plans:

  • Earnings are tax-deferred, withdrawals are exempt from federal income tax and are also generally exempt from state tax for “qualified higher education expenses” (books, supplies, tuition, fees, room and board).
  • Contributions are not limited to the account holder. Friends and family members can also contribute to the plan.
  • If the beneficiary does not use all the funds or decides not to attend college, the account holder can change the beneficiary to another family member (i.e. sibling, parent).
  • The account holder has control of the funds, not the beneficiary.

Here are some of the disadvantages to consider:

  • Plans vary from state to state. Some 529 plans have better investment choices and low fees, but others may have terrible fund selections and higher fees.
  • If withdrawals are not used for “qualified higher education expenses,” the earnings may be subject to income tax plus a 10% penalty tax.
  • Balances in a 529 plan may reduce your beneficiary’s ability to receive financial aid.

The bottom line is that 529 plans are not for everyone. They’re also not the only option available for paying for college. Setting up a 529 plan is an investment decision, which means both the benefits and drawbacks must be considered, along with alternative ways of accomplishing the same thing.
For more information on 529 plans, check out a list of 529 plans and questions and answers from the IRS.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. Under no circumstances does this information represent a recommendation to buy or sell securities.

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