529 Plans: Best Bet?

I wanted to kick off my part of our new blog series with a topic that seems to get a lot of hype; however, nobody ever talks about the drawbacks. Section 529’s can be a great vehicle to accumulate money for your children, grandchildren, nieces or nephews, in the right economic environment. There are many benefits to 529 plans, but depending on your risk tolerance and whether you want your contributed money to be guaranteed for your children’s college, they may not be all they’re cracked up to be.

Must be used for education

When contributing to a 529 plan, many families think, “If I contribute to a 529 plan, it’ll force these funds to be used for my children’s college education.” But what happens to the family who pours so much money into their 529 that they have too much for college? Or the family whose son decides to join the military at the age of 18? If they want to keep that money, they must use it on another child or pay the 10% penalty fee on top of the income taxes. Yes, overfunding a 529 plan is rare, but it does happen. Funds in a 529 plan must be used for qualified educational expenses. Anything else will be charged with the penalty fee and income tax.

Market Risk

Funds added to a 529 are subject to market risk, much like a 401 (k) or IRA. What happened to the families who were ready to send their children to college in the market crash of 2008? Many saw the value of their 529 plans decrease by 30%. This led to increased borrowing and higher student loan debt for students in college at this time. Part of the draw to 529 plans is the fact that they are tax deferred and withdrawn tax free if they are used for qualified educational expenses. The power of compounding can be on your side if it is held long enough. However, for many people who want the money to be there when their children are ready for college, sometimes it is not. A funding plan should be in place, not just a 529 with money thrown at it hoping for the best.

Financial Aid Reduction

A 529 plan is considered the asset of a parent and assumed that it will be used for education. Therefore, when the parents’ incomes and assets are assessed, the 529 plans are thrown in with checking accounts, brokerage accounts, and other non-qualified money. These 529 plans are assessed at 5.65% and then added to the expected family contribution (EFC) each year. So a family who has $50,000 in a 529 plan for their daughter will receive $2,825 LESS per year in financial aid. 

Parents and grandparents wanting to save for college should weigh all savings options before choosing the one that suits them the best. While there are certainly some advantages to investing in a 529 plan, especially if you are bullish on the market, they certainly have their downfalls. Counting on a 529 plan as your main source of funding could highly disappoint you when your child approaches his or her first year of college.

Chris Horan, College Planning Specialist