If you’ve been looking for ways to start a college fund for your child, one popular option that you’ve likely come across is a 529 plan.
This type of plan is intended specifically for saving for college, so it can make higher education much more affordable. With enough contributions, you could pay for your child’s entire education -- or at least drastically reduce the amount they need to borrow in student loans.
While 529 plans have plenty of benefits, there are also some notable disadvantages. To know whether opening a 529 plan is the best choice, you should be aware of all these pros and cons.
Pro: You can choose to prepay for credits or invest your money
There are two options available with 529 plans:
- Savings plans: Your money is invested, most often in a mutual fund, and growth will depend on the performance of that investment.
- Prepaid plans: You buy tuition credits at the current prices, and your child can use them later to pay for college.
Both options can result in your plan being worth much more than you invest. With a savings plan, your money could grow considerably depending on how the investments perform -- although there is also the possibility that the value could drop during a down period in the market. To avoid the latter, investments usually get more conservative as your child gets closer to needing the money in their plan.
With a prepaid plan, you’re locking in tuition prices at the time that you buy those credits. Given that tuition prices at public four-year institutions increased 213% from 1988 to 2018, a prepaid plan could allow you to pay much less for tuition than you would in the future.
Con: Investment options can be limited
When you invest your money in a 529 plan, you’re giving up the control that you’d have if you were investing it on your own. Plans typically offer different preset investment options for you to choose from. You can’t simply pick whatever funds you want like you can through your own stock broker.
You can also only change your investment choice up to two times per year. So if you’re the type that likes to manage your investments, you could find yourself frustrated with the lack of control you’ll have over a 529 plan.
Pro: 529 plans provide tax advantages
One of the biggest benefits of 529 plans is the tax advantages that they offer for both the parent who contributes to the plan and the child who uses it.
Although contributions to a 529 plan aren’t deductible from federal income taxes, many states will let you either get a tax deduction or a tax credit for your contributions on your state taxes. Withdrawals for qualified education expenses are tax-free.
Con: There are restrictions on how the money can be used
Since a 529 plan is intended for qualified education expenses, that is the only way you can use it without incurring taxes and fees. While there is some flexibility (see below), if you need to withdraw money for anything else then you’ll pay a 10% fee, as well as income taxes on your plan’s earnings.
This could leave you in a difficult position if your child decides they don’t want to pursue higher education or if they go to school but don’t need to use the full balance of the plan for their college expenses.
Pro: You can transfer your plan
529 plans provide plenty of flexibility in how the funds can be used. For example, you can transfer the plan to another child in your household. That means if your oldest child decides school isn’t for them or if they don’t need all the money because they have other ways to pay for college, such as scholarships, then you could transfer the 529 plan to a younger child.
Your child can also use their plan to pay for school in any state. Even if you get a prepaid plan and purchase tuition credits in one state, it is still possible to use the funds to attend college somewhere else.
Con: It can affect eligibility for financial aid
To apply for financial aid, college students must fill out the Free Application for Federal Student Aid (FAFSA®). The FAFSA® requires information about the financial situation of the student’s parents, including income and assets.
As a 529 plan is considered an asset, it can lead to the student having a higher expected family contribution (EFC). A higher EFC means less financial aid opportunities.
Pro: The parent has control of the plan
While a 529 plan is in the name of the beneficiary, the parent or guardian who opens the plan is the owner and controls what the money is used for. You won’t need to worry about your teenage child deciding to cash out their college plan and use it for something entirely different.
Deciding if a 529 plan is worth it
A 529 plan is a smart choice if you’re confident that your child will be attending college and you want something that doesn’t require much management on your part. You’ll get the most benefit from it the earlier you open it, as this will allow more time for the funds in the account to grow (or for college costs to rise if you go with a prepaid plan).
The biggest potential problem with 529 plans is the penalties when the funds aren’t used for educational expenses. If that’s a deal breaker for you, then look for other college fund options.