By Janet Stanton Burt
College savings 529 plans are a great way for parents to invest for a child’s college education, but they aren’t perfect. You can make the most of your 529 plan investment dollars by avoiding these six mistakes:
1. Designating the wrong account owner.
529 plans owned by someone other than a custodial parent can reduce your child’s eligibility for need-based financial aid.
When grandparents, noncustodial parents, aunts, uncles or other people own the 529 plan for your child, any money withdrawn to pay for college counts as student income.
That “income” can reduce your child’s eligibility for need-based financial aid by as much as 50% of the distribution amount, according to Mark Kantrowitz, senior vice president and publisher for Edvisors.com.
The best way for well-meaning family members to help with college costs is to contribute directly to a 529 plan owned by the child’s custodial parent.
Naming the student as the owner of the 529 plan can similarly harm financial aid chances. When parents own the 529, the student aid formula expects them to spend 5.64% of it for college expenses each year. When the student owns the account, the formula assumes he’ll spend 20% of the funds.
2. Choosing a plan without researching fees and tax incentives.
Not all 529 plans are the same, so it pays to do your homework.
For example, many 529 plans charge annual maintenance fees that add up to significant money over time. The Street reported that investors in Washington, D.C.’s 529 plan paid $2,404 in fees over 10 years.
Other 529s don’t charge fees. The only way to see what you’ll pay in fees is to read the prospectuses and program descriptions.
State tax benefits vary, too. Bear in mind that you don’t have to invest your college savings in your home state’s 529, but you may get special tax incentives or credits for using it.
Start by investigating what your home state offers, then comparison shop by looking at each fund’s fees, long-term performance and the state tax advantages. Consider whether your risk tolerance matches the investment products in the fund.
3. Using 529 money for the wrong expenses.
The tax advantages of a 529 are only available if you use the funds for qualified higher education expenses, like tuition, some room and board and supplies and equipment required for enrollment.
For instance, the cost of a new laptop doesn’t count as a qualified expense unless the college requires students to have their own personal computer.
Funds withdrawn from a 529 beyond those qualified annual amounts are subject to a 10% penalty tax if the money you take out came from earnings (rather than contributions you made). You could owe income taxes on the surplus funds, too.
Do you know how much to save for college? The first step is to get a reasonable estimate of the education costs you’re saving for and decide how much you can put away each month. Let Goal Investor help.
4. Withdrawing too much in one year.
Did your child earn a scholarship or institutional financial aid? You have to subtract the total of those funds from your maximum qualified expenses. Skip this step and you could incur penalties for excessive withdrawals.
Also pay attention to the timing of your 529 plan withdrawals to make sure you don’t take out more than the allotted qualified expense amount for the year.
This can sometimes happen when you withdraw money from a 529 plan in late December to pay spring semester tuition in early January.
Withdraw money as close as possible to the time of your education payment to avoid this problem.
5. Paying college bills directly from your 529 plan.
There’s no penalty for having the distribution check from a 529 plan go to you, or your student, as long as the money is used for qualified education expenses. Don't have your 529 plan administrator write the check directly to your child’s college. Some schools view money coming directly from a 529 plan the same way they view scholarships, and may reduce their own institutional financial aid to your student accordingly. To be on the safe side, have 529 plan withdrawals come to you first.
6. Overfunding your 529 plan.
Earnings on 529 plans are tax-deferred, and generally tax-free as long as you spend withdrawals on qualified expenses. If your kid doesn’t end up going to college, or her chosen college costs are less than you expected, having too much saved in your 529 plan might be a problem.
You can always use those 529 funds for another child, grandchild or even for your own continuing education by changing the beneficiary on the account. If that’s not an option, you’ll need to take a nonqualified withdrawal, and pay income tax and penalties on the earnings portion of the withdrawal.
To help avoid this issue, we believe you should save no more than 80% of your child’s total estimated college expenses in a 529 plan.
In spite of these drawbacks, 529 plans have many advantages:
- Tax-free earnings growth
- Tax-free withdrawals
- The potential for state tax deductions or credits on contributions
- Parent control of account funds
Start saving as soon as you can for your child’s college education, even if you can only manage a little at first. Every dollar you save today is a dollar you won’t have to pay to borrow tomorrow.
Ready to get started? The Goal Investor College Savings Planner can help you calculate a reasonable education goal and a savings plan to help you reach it.
This information is provided for educational purposes only and is not intended to provide investment or legal advice. SEI does not claim responsibility for the accuracy or reliability of the information provided.
Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.