Americans have been slow to embrace 529 college savings plans, which were introduced in the mid-1990s. Just 21 percent of American families paying for college used the plan in 2019, according to a report from Sallie Mae.
A 529 plan allows you to invest in high-return assets, avoid taxes on the capital gains while in the account and then withdraw those earnings tax-free for qualified education expenses.
While tax-free investing can be a major upside, the plans have some downsides, which may help to explain why so few people know about them or use them.
1. Investment choices can be limited
A 529 plan may allow you to invest in a number of different assets, including stock funds, bonds funds, and FDIC-protected money market accounts. Many states also offer target date funds that adjust the mix of your investments so they’re less risky as you approach the time to use the money.
But 529 plans are administered by each individual state, and the plans may not offer an attractive investment opportunity, depending on which plan you choose. For example, some state plans may offer only high-cost funds or a limited selection of such funds.
For those with investment expertise, that can be a significant downside over investing the money in more attractive things such as individual stocks. It may be even worth paying taxes in a taxable account to be able to invest in these other options.
Matt Gallagher, founder of Odinic Advisors in Plymouth, Massachusetts, says that while he set up a 529 plan for his oldest child, he’s opted for taxable brokerage accounts for his younger two children.
In Massachusetts, Gallagher says, “I really don’t like the investment options in target date funds and general basic ETFs. I would rather have the flexibility of a brokerage account and its investment options than the state tax benefits of a 529.”
For those without the expertise to pick their own investments, however, the limited options may be acceptable and even preferable.
“The fewer investment choices can be a mixed blessing,” says Holmes Osborne, principal at Osborne Global Investors. “It also can keep people from getting into trouble with crazy ideas.”
2. Not all 529 plans are the same
State plans are literally and figuratively all over the map. While the broad outline of the 529 plan may be clear – tax-free distributions for qualified investment expenses, for example – much of what goes on within a state’s 529 is up to the state itself.
“529 plans are creatures of state statutes, so each state has their own plans and requirements,” says Gallagher. “Some offer state tax deductibility for contributions, but not all.”
The 529 plans may also differ by the kinds of investments you can make, the costs of those investments, minimum contributions and how the plans are administered more generally.
All these distinctions mean that you’ll have to invest more time to understand how one state plan differs from another and what the tradeoffs are for each. But it’s important to find the best plan for your needs.
3. You might easily trigger a penalty
The rules on 529 plans are strict. The most important one is this: you must use funds in a 529 account to pay for qualified educational expenses. Otherwise, you’ll owe taxes on the investment gains at whatever the IRS would normally charge you plus an additional penalty rate of 10 percent.
Qualified education expenses include tuition and fees, room and board as well as textbooks. They may also include other expenses for attending college such as a computer and software used primarily for the classroom.
While those rules may be easy enough to understand and follow, it’s possible to accidentally trigger a penalty even with the best of intentions.
For example, a parent might withdraw a full year’s tuition at the start of the school year in fall. However, only one semester’s tuition is due then, while tuition for the spring semester is due at the start of the following calendar year. So this extra withdrawal would incur regular taxes plus the bonus penalty, even though the parent had every intention of using it for qualified expenses.
Some lower-income families may be just as well off to save in a regular taxable account as in a 529 plan without the restrictions. That’s because a couple filing jointly would pay no long-term capital gains taxes on investments as long as their modified adjusted gross income was below $78,750 (in 2020).
Some savers might think that the additional restrictions on 529 plans are not worth the hassle.
4. 529s count against you for federal aid
College is expensive enough without doing things that minimize the amount of free money that you can receive. And a 529 plan can count against you in the calculations that determine your eligibility for aid.
“The 529 assets count against the account holder when applying for a financial aid package,” says Mark Charnet, founder & CEO of American Prosperity Group. “The greater the assets in the plan, the less aid is available from grants, loans and financial scholarships.”
It’s important to note, however, that the hit to financial aid depends on who owns the account. Assets in a parent-owned 529 account may ding the family’s expected contribution amount by five percent, while a student who owns the account might take a hit of about 20 percent. It could get worse if another relative owns the account.
5. Contributions and fees can be high
“Be careful of fees,” says Ksenia Yudina, CEO and founder of UNest, a college savings app to help families to save for education. “Parents can easily end up seeing a significant percentage of their savings go to the financial institution or investment manager running the 529.”
Fees may be higher than they otherwise would be if you had a wider selection of options — another part of the downside of limited investment options. Your state 529 plan may offer only relatively high-cost ETF index funds, for example. And with low-return options such as bond funds, a higher expense ratio can really hurt the total return.
These funds charge an expense ratio as a percentage of the amount you have invested in them. Higher-cost funds might charge you 0.5 percent or more annually, or about $5 for every $1,000 invested. That might not seem like a lot, but low-cost funds today are priced under 0.1 percent, or $1 for every $1,000 invested.
Also, don’t forget that as your money grows, you’ll be paying more each year for the fund. And this expense can nibble away at your returns over time.
Yudina also cautions savers to examine how much a state’s plan requires them to add each month.
“Many plans require a minimum contribution of hundreds of dollars a month,” she says. “This is beyond the reach of many families.”
Alternatives to 529 plans
With the rapidly rising cost of a college education, parents need an option to make it affordable, and
some have turned to a number of other solutions.
1. Taxable brokerage accounts
One of the most obvious is to use a taxable account and start early. Capital gains on stocks, bonds and funds won’t be taxed until they’re sold, so you could keep any capital gains tax-free in an account for a long time and let them grow. Plus, you’d have flexibility on when you use the money and for what, without having to deal with the 529’s limits, if those concern you.
2. Roth IRA
Some families turn to a Roth IRA to save for college, because the money can grow tax-free. If you’re under 59 ½, you can withdraw any contributions tax-free, while those over that age can take out any money tax-free. This flexibility is important to many, but using the Roth IRA for this purpose has several disadvantages, not least of which is depleting your retirement account.
3. UGMA account
A third alternative that provides flexibility is a uniform gift to minors account (UGMA), which is a custodial account that allows adults to transfer assets to minor children. One key advantage of the plan is how they’re taxed: in these accounts a portion of the gain is tax-free, a portion is taxed at the child’s tax rate, while the remainder is taxed at the parent’s rate.
A UGMA offers substantial flexibility in how the funds are invested and used. “The participant is not forced into any particular course of study or education track at all,” says Charnet.
But he notes this caveat to a UGMA: “A UGMA account belongs to the child upon reaching the age of 18, so a better strategy may be for the parents to keep the account in their own name.”
Whichever choice you make for saving for a college education, one of the most important decisions you can make is to start today. By beginning early, you’ll give your money time to compound, and that’s where a huge share of your account value will come from over time.