A 529 is a state-sponsored investment plan designed to help parents and other adults fund a child’s future educational costs. When they’re ready, the account beneficiary can make tax-free withdrawals to pay for eligible education expenses.

However, a 529 plan may not be the best choice if you’re not sure if your child will go to college, how much money your child will need for college or if you like to be more hands-on with your investments.

How does a 529 plan work?

Funds in a 529 plan can be withdrawn tax-free as long as they’re used for qualified educational expenses, such as tuition, fees, room and board, books and housing at colleges and universities, technical and vocational schools, apprenticeship programs and, in some states, private K-12 schools.

The tax-free use of the funds is restricted to educational expenses only, so if your child chooses not to pursue an educational path, you’ll incur taxes and penalties when you withdraw the funds.

If you open a 529 plan early, you could see sizable growth in your account by the time your child pursues their postsecondary education.

These plans are administered by individual states, but you’re not limited to the 529 plan offered by your state. If you’re an active investor, you’ll have no involvement in the investments the plan administrators choose to make. Some plans take a more conservative investment approach, meaning your funds may grow at a slower rate.

Pros and cons of a 529 plan

While a 529 plan is one of the more well-known savings vehicles for college funds, there are benefits and drawbacks to consider.

Pros

  • Tax benefits: In more than 30 states, account owners can receive tax credits or deductions when they contribute to a 529 plan. The amount of the credit or deduction varies depending on the state.
  • Earnings grow tax-free. The money in a 529 plan grows tax-free and can be withdrawn tax-free as long as it’s spent on qualified educational expenses.
  • Beneficiaries can be changed. If you have more than one child and the child who is the account beneficiary doesn’t use all of the funds in their 529 plan, you can change the beneficiary to the other child without incurring fees or penalties.
  • The funds in 529 plans can be used to pay student loans. Funds do not have to be used when in school if they go toward loans.

Cons

  • Noneducational expenses may incur penalties. While contributions to a 529 plan can be withdrawn for any reason, earnings that are used for nonqualified educational expenses are taxed and charged a 10 percent penalty.
  • Some plans have high fees. There are no federal regulations on 529 plans. Some state plans charge high fees that can eat away at your earnings.
  • Investment choices may be limited. Each state sets investment choices for its 529 plans. Some plans are more limited than others, meaning the return may not be as high.
  • Federal aid may be reduced: 529 plans could reduce the scholarships and grants your child could receive. These funds count against the family’s expected contribution. That figure varies depending on who owns the account — the student, parent or grandparent.

When is a 529 plan a bad idea?

A 529 plan is not a good choice for every family. It may be a bad idea if:

  • You live in a state that doesn’t offer tax credits or deductions for 529 plan contributions, and you don’t want to start a 529 plan in a different state.
  • You’re not sure if your child will attend college. If you start a 529 plan when your child is young, you have no idea what that child’s career interests will be when they graduate high school. If your child does not pursue additional education, you may lose all the tax benefits of the 529 plan.
  • You’re not sure how much money you’ll need to save for college. In the 10-year period from 2010 to 2020, college tuition increased 31.4 percent. The average cost of tuition at a public four-year college or university was $7,132. In 2020, that figure jumped to $9,375. And this does not include the costs of room and board, fees or books. This rising cost of education makes it difficult to know how much you should be contributing to a 529 plan.
  • You have investment experience and prefer to choose from a wide range of investment options than be limited to the investment strategy used in the state’s 529 plan.
  • You would lose out on federal financial aid. Since a 529 plan could reduce the amount of federal aid your child would qualify for, they may miss out on receiving federal Direct Loans or Direct PLUS Loans or grants, like the Pell Grant or Federal Supplemental Educational Opportunity Grant.

Alternatives to 529 plans

If you don’t think a 529 plan is the best option for you and your child, you can consider some alternative options.

Brokerage account

A brokerage account is an investment account where you can contribute money and invest it in the stock market. When you withdraw funds, you will owe capital gains taxes on any profits, though you can use funds for any purpose — not just an education.

Unlike with a 529 plan, there are no tax credits or deductions available for brokerage accounts, which are also far more likely to impact your child’s eligibility for financial aid.

Roth IRA

A Roth IRA is a type of retirement account that uses after-tax dollars. You can withdraw contributions at any time without facing fees or penalties, and earnings may be withdrawn without penalty if they’re used for educational expenses. The benefit of using a Roth IRA instead of a 529 plan is you’re not required to use the funds for educational expenses, so it could be a good option if you’re not sure if your child will pursue secondary education or, if they do, how much money they’ll need.

However, a Roth IRA isn’t designed for college savings. It’s a retirement account, so any money you withdraw to pay college costs will eat into your retirement savings. Taking distributions may also hurt your child’s chances for financial aid.

Custodial account

A custodial account is a savings plan that allows a minor to take ownership of the account upon reaching adult age — either 18 or 21, depending on each state’s rules. You can withdraw funds anytime as long as they are for the designated child’s benefit. When the child reaches adult age, they can withdraw funds for any purpose.

There are also tax advantages to custodial accounts. Some earnings on the account are tax deductible. Once that threshold is reached, earnings are taxed partially at the adult’s tax rate and partially at the child’s tax rate.

The bottom line

While there are benefits to these programs, there are also a lot of drawbacks that make a 529 plan a bad idea for many families. It’s important to research all the investment options before choosing to invest in a 529 plan.