The Pros and Cons of a 529 Plan

Adjusted for inflation, a year of college cost $4,300 in 1963. Today, that same year will cost you over $14,000. The more tuition costs rise, the more necessary it becomes to start saving for college as early as possible. Opening a 529 college savings plan can be a great way to afford a  degree while minimizing student loan debt. 

In 2022, 33% of American families used a 529 college savings plan or other investment account to pay for some portion of their child’s college education. If you want to help your child pursue a college degree and avoid student loans, explore the pros and cons of opening a 529 college savings plan. 

What is a 529 plan? 

A 529 plan is a tax-advantaged investment account specifically for college expenses. Like a Roth IRA, a 529 plan requires families to contribute post-tax dollars. Then, when it comes time to pay for college costs, the account beneficiary can withdraw any investment earnings without owing the IRS additional taxes (so long as the money is used for qualified educational expenses).

What are the different types of 529 plans?

Outside of the traditional 529 college savings plan, there’s another type of 529 plan, known as a “prepaid tuition plan.” These are more limited and often come with state residency restrictions. As the name suggests, a prepaid tuition plan involves purchasing credits to be used in the future at corresponding universities and colleges. 

How to open and use a 529 plan 

Contributing to a 529 plan is fairly straightforward, but there are some specifics you should know before you open one. Here’s how the process should work from start to finish. 

Research your state’s plan 

529 plans differ by state. Some states offer matching plans. Others might provide seed money to get your savings started. Explore different options and providers. Keep in mind: you do not have to open a 529 plan specific to your home state, though you may receive better tax benefits if you do. 

Decide which type of college savings plan you want

Understand the differences between a 529 college savings plan and a prepaid tuition plan. Depending upon where you live and where your child plans to go to college, your choice might be easy. In 2023, only 10 states still offer prepaid tuition plans. If you have the ability to enroll in both or either, determine which is right for your family and identify the corresponding plan. 

Decide who will open the 529 plan

Anyone can open a 529 savings account: parent, grandparent, step-parent, guardian, friend, or even the student themselves. In most cases, 529 plans are created by a parent on behalf of a minor child. But there’s no rule regarding the relationship between the account owner and the beneficiary. 

Select a beneficiary

Like many custodial accounts, the 529 plan beneficiary is usually the child of the account owner. But pretty much anything goes as long as the beneficiary is a U.S. citizen or legal permanent resident with a social security number. You’re also allowed to change the beneficiary at any time. If you’re a parent with multiple children, you’ll either need a separate 529 plan for each individual child, or to change the beneficiary from one child to another. 

Determine how much you want to contribute at the outset

During your research, you’ll discover that some plans require participants to start their accounts with a minimum investment. Do some careful financial planning and decide how much you want to contribute to your child’s college fund today. If you have a financial advisor, ask for their insight. Many plans charge annual fees for custodial services like investment management. Factor these costs into your initial investment. 

Open your 529 plan

Today, most 529 plans can be opened online. Just visit your provider’s website and sign up for an account. With most 529 plans, you won’t be charged an enrollment fee. If your plan does carry this fee, it shouldn’t be too high –– usually around $50. After you’ve set up your account, deposit your initial investment. Depending on your plan, your initial investment requirement could be as low as $25. 

Choose your portfolio

Most plans are passively managed – meaning the provider chooses where your money is invested. Though you can’t choose exactly where your money goes, you usually can choose your level of risk tolerance and an age-based strategy. This allows your provider to invest in alignment with your child’s education timeline.

Plan your future contributions

Some plans require account holders to continue to contribute on a regular basis. Familiarize yourself with your 529 plan’s requirements and plan out your future contributions. If you have a sense of how much your child’s education might cost, use this number to create an investment goal. 

Monitor your savings

Deposit your money, contribute when you can, then monitor your savings. Returns will vary based on a number of factors like length of investment, portfolio strategy, and the strength of the market. In 2022, the average 529 plan held $25,903

Withdraw your earnings for qualified educational expenses 

When the time comes to pay tuition bills, tap into your 529 plan. The one caveat to tax-free withdrawals is that 529 plan earnings must be spent on qualified educational expenses. This includes college costs like tuition, fees, room & board, books, etc. 

The pros and cons of a 529 savings plan

Depending on how early you open your 529 plan and how much you regularly contribute, you could tuck away a healthy sum to put toward your child’s education. That said, there are some disadvantages to opening a 529 plan, too. Here are a few reasons why a 529 plan may, or may not, be right for your family.

The benefits of a 529 plan 

Easy to open and maintain 

With so many different options available online, opening a 529 plan is an easy process. And thanks to passively managed plans with flexible commitments for continued investing, maintaining your 529 plan is hassle-free. Your account can grow with minimal time and effort on your end.

High contribution limit 

If you’re in the financial position to dedicate a lot of capital to your child’s education, 529 plans can be a great choice because they don’t technically have annual contribution limits. 529 plan contributions are considered gifts and are subject to gift tax rules. But you don’t need to worry about gift taxes unless you’re planning to contribute more than approximately $15,000 per year to each child’s 529 plan. The aggregate limits on the amount of money that can be held in a 529 plan vary by state

Grows on a tax-deferred basis  

With a 529 plan, you’ll contribute post-tax dollars. Then, your money grows on a tax-deferred basis, which means none of your earnings will be subject to taxation while in the account. Since you won’t pay tax on investment income or capital gains, your money has the opportunity to compound significantly faster.  

Withdrawals are income-tax-free 

When 529 plan earnings are spent on qualified educational expenses, you can withdraw them from your account tax-free. On the other hand, if you use 529 plan earnings to pay for non-qualified educational expenses, you’ll be subject to taxes plus a fee. 

Some state tax deductions 

Depending on where you live, you might get a tax break for your 529 plan contributions. In 30 states, you can write off your 529 plan contributions entirely. Learn the tax credit options in your home state before you commit to a plan. 

Minimal effect on financial aid eligibility 

While a 529 plan could have some effect on your financial aid eligibility, the impact should be minimal. Money distributed from a 529 plan does not count as income on a student’s Free Application for Federal Student Aid (FAFSA®). However, the capital held in the account will be reported as part of the parents’ assets. Any 529 plans held by a person other than the student or parent will not factor into a student’s FAFSA® at all (though distributions may affect the child come junior year).

The disadvantages of a 529 plan 

Costs vary 

Depending on your state and account provider, the costs to open and maintain your 529 college savings plan could vary. Most of the time, these fees are minimal and range between $10 and $25 per year. If you’re taking advantage of a financial advisor or another managed account, you could pay investment fees, which can add up. As with any type of investment account, make sure you understand all possible fees before you open one. 

Not eligible for federal tax deductions or credits 

While some states offer tax deductions for money contributed to 529 plans, the federal government does not. You’ll pay federal income tax on the money you contribute to your child’s 529 account and won’t be able to write these earnings off like you would contributions to a retirement account. 

Limited investment options 

Due to IRS rules, 529 plan account owners are not allowed to choose how their capital is invested. This means you don’t get to choose the exact stocks, bonds, or mutual funds in your portfolio. While this can be a downside for some, allowing a financial advisor or provider to make investment decisions might be the best-case scenario, particularly if you don’t have a strong financial background.

Strict ownership rules 

The account owner of a 529 plan holds all of the legal power. They can change the beneficiary or liquidate the account (with penalty) at any time. This could be a disadvantage if the owner of your or your child’s 529 plan has a change of heart about where to direct their investment. If they find themselves in a financial emergency, for example, they may have no choice but to liquidate the account, leaving you and your child scrambling for other ways to pay for college.

529 plan FAQs

What happens if I don’t spend my contributions on eligible educational costs

If you use distributions from your 529 account to cover anything other than education costs, you will face a penalty. You will be able to withdraw your money from the account but will be responsible for income taxes on the earnings – federal, state, and county if applicable – as well as a 10% penalty fee. 

Can I transfer my 529 plan? 

Yes. It’s possible to transfer your 529 plan from one state to another. Unless you’re planning to withdraw your capital, you’ll have to roll your existing 529 plan over into another 529 plan. It’s simple enough to transfer plans between states and providers. However, you’ll want to brush up on the state income tax rules before you pull the trigger. If you’ve received tax breaks in one state due to your 529 plan, you might be required to return those savings if transferring to another state’s plan. 

What’s the difference between a 529 savings plan and a Coverdell ESA

Both a 529 college savings plan and a Coverdell Education Savings account (Coverdell ESA) are investment accounts intended to be used for educational purposes. Coverdell ESAs function almost identically to traditional 529 plans. However, in order to qualify for a Coverdell ESA, your family’s income must be below a certain threshold. Another hallmark difference is that Coverdell ESA’s have a lower annual maximum contribution and the funds must be used or withdrawn by the beneficiary’s 30th birthday. 

Do I lose my savings if my child decides not to go to college? 

No. Even if your child doesn’t pursue a traditional four-year degree, there are other higher education options like vocational schools or apprenticeship programs that qualify for 529 plan earnings. Additionally, if your child attends private school you can use some portion of 529 plan earnings for K-12 tuition. 

Get matched to scholarships with Going Merry

Signing up for a 529 college savings plan can be an ideal way to kickstart your child’s college fund. While you’re saving up for your child’s college tuition, explore other ways to lower those bills. One of the most lucrative options is college scholarships. With Going Merry, you’ll gain access to thousands of high-quality scholarship programs for every type of student. Just sign up, create a profile, and your child will be matched to awards that they’re already eligible for. Ready to start? Sign up for free and get high-quality scholarships delivered to you.

Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.

Going Merry is an affiliate of Earnest. Going Merry will exclusively offer the Earnest Private Student Loan Program for you to consider to help you cover the unmet costs associated with your higher education. Earnest Private Student Loans are made by One American Bank, Member FDIC.


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