A 529 plan is a great way for parents and other family members to save for a child's education. By using a 529 plan, you can ensure you're intentionally saving for a child's future while receiving tax benefits. Money in a 529 plan grows tax-deferred with tax-free withdrawals for eligible educational expenses. However, 529 plans aren't without their faults. Here are three downsides to a 529 plan every parent should know while saving for college.
1. Investment options can be limited
Unlike a regular brokerage account or individual retirement account (IRA), you have limited investment options with a 529 plan. The plan manager chosen by your state provides you with your investment options, which can be limited -- especially for more experienced investors who'd prefer the freedom to choose whatever investments they want.
One of the investment options is usually an age-based portfolio, which will adjust the assets in the account as your child ages. The further away from college your child is, the riskier the portfolio will be (more stocks). As your child gets near college age, the portfolio will become more conservative and focus more on preserving the money versus taking more risks to grow it.
There will also usually be a static portfolio option, which remains the same unless you choose to manually reallocate the investments. Some will include target-risk portfolios based on how much risk you're willing to take; for instance, "conservative," "moderate growth," or "aggressive growth." Individual portfolios will mirror certain indexes or other mutual funds. For example, Fidelity's 529 plans offer "Fidelity 500 index Portfolio" and "International Index Portfolio" options.
2. It's used when determining aid eligibility
When your child fills out their Free Application for Federal Student Aid (FAFSA), your family's total financial situation is considered -- including the 529 plan. Your child's Expected Family Contribution (EFC) -- used to determine how much you can pay out-of-pocket for school -- will increase with the 529 plan total. The higher your EFC, the fewer federal grants, subsidized loans, and work-study opportunities your child will likely receive.
Since a 529 plan is considered an asset, who owns the account is important. If the account is in a parent's name, up to 5.64% of the amount saved is counted toward your child's EFC. However, if the account is in the child's name, up to 20% is counted.
3. It's easy to trigger penalties
The purpose of a 529 plan is to pay for qualified higher education expenses. However, it's important to know which school-related expenses qualify. You can use your 529 plan to pay for the following:
- Tuition and fees.
- Books and supplies.
- A computer and software.
- Room and board (if the student is enrolled at least half-time).
- Student loans (up to $10,000 in a lifetime).
Unfortunately, transportation costs -- such as air travel or gas to get to and from campus -- are not covered, nor are expenses like college applications and test fees, extracurricular activities, or health insurance. If you make a withdrawal to pay for an ineligible expense, the IRS will consider it income and tax it accordingly, along with a 10% fee. Not knowing which expenses are eligible for 529 funds can result in an unexpected tax bill and cost you more than you planned.