It is to no one’s surprise that parents often start a college savings fund for their child shortly after the child’s birth. College is an expensive investment that most parents are willing to assume for their children. To financially prepare their children for college, most parents choose 529 college saving plans due to tremendous tax benefits. In fact, the 529 savings plan balances hit an all-time high by nearing $330 billion in 2018.
While most parents are investing in a 529 because it’s considered one of the best options for college savings, it is also important to be informed about the downside of this option which may result in fees and penalties.
1. Could have high fees
Not all 529 plans are created equally. It’s important that you do the research and shop around for different 529 state plans to find the best investment options, benefits, and affordability. Like any other investment vehicle, there are fees associated with a 529 plan. While you may be able to find a state with a low maintenance cost plan, there are often high enrollment fees instead.
According to Investopedia, a 529 savings plan resembles a typical 401(k) plan where the investment options are limited depending upon your state plan. However, these two plans differ in an important way: unlike a traditional savings account where you can adjust your investment at any time, a 529 savings plan only allows two changes per calendar year.
3. Penalty for non-qualified withdrawal
The biggest disadvantage of the 529 plan is its inflexibility regarding withdrawals. A 529 savings plan can only be used for qualified educational expenses on behalf of its beneficiary, such as tuitions, books, and room and board. Expenses such as car insurance payments on the vehicle used to get to classes do not fall within the 529 plan scope
Additionally, if you want to make a withdrawal at an earlier date or for any other non-qualified purpose, you’ll most likely be charged with a 10% penalty. While a 10% penalty is common across the board, there are additional charges certain plans may have.
If your child decides to not go to college or pursues a career in the military where their school will be paid for by the government, it does not mean you’ll get your money back completely. If it turns out your 5-year old becomes an 18-year old who wants to pursue a different path, there are only a few options available. You can change the name of the beneficiary; perhaps there is another sibling who hasn’t had a 529 plan set up yet, or you can wait to place it in the name of a grandchild. Better yet, if you decide to pursue higher education – like a master’s degree – then you can be named as a beneficiary yourself.
If one of these options or scenarios does not fit your situation, you still may be able to recover a portion of the money after paying non-qualified withdrawal fees. How large of a “loss” that amounts to depends upon the 529 plan you have chosen.
4. Non-qualified withdrawal exception when winning scholarships
Like any rule, there’s always an exception. In regards to 529 plans and scholarships, there’s actually good news. The 10% penalty fee does not apply to scholarships. What does this mean? 529 plan investors can take non-qualified withdrawals from their account, up to the amount of scholarship awards received. It is important to note that you can’t avoid the tax on those earnings. If your child is awarded a scholarship make sure to ask for a scholarship receipt for your tax records.
Many Americans are taking advantage of tax incentives such as the American Opportunity Tax Credit or Lifetime Learning Credit. While it may seem like there is never too much of a good thing, tax incentives like the two previously mentioned do not go well with a 529 Saving Plan. For example, according to Forbes, if you take $12,000 out of a 529 college savings plan to pay for tuition, you cannot also use that $12,000 of tuition expenses to claim the American Opportunity Tax Credit. For this reason, it’s important that you understand the tax intricacies and complications that may arise if you choose to prepare your taxes yourself at the end of the year. A certified tax preparer will be able to help you navigate through laws and policies, and will help you make the most of the benefits for which you qualify.
A 529 college savings plan can be a great way to pay for college when you know how to manage it correctly. If you’re still not convinced about a 529 plan, or have exhausted your savings limit, another alternative is building your fund in a high-yield savings account or a certificate of deposit. While it may not have the tax benefits or the growth that is promised in a 529, alternatives such as a CD allow you to have greater flexibility in your spending.