Pros and Cons of 529 Prepaid College Plans
As the cost of higher education continues to rise, many families face the daunting task of saving for their children’s future academic endeavors. 529 plans are a popular and potentially effective option for saving for college. Simply put, 529 plans are tax-advantaged education savings vehicles where the funds are earmarked only for college tuition. However, like any financial instrument, 529 plans have their benefits and limitations.
How 529 Plans Work
A parent, grandparent, or any other person can open a 529 account and name a beneficiary (usually a child or grandchild). The account owner can contribute money to a 529 plan. States typically offer tax deductions or credits for contributions, although this varies by state.
The money in the account is invested in mutual funds, exchange-traded funds (ETFs), or other investment portfolios. Most 529 plans offer age-based options that automatically adjust the investment structure to be more conservative as the beneficiary approaches college age. Investments in the account grow tax-free at the federal and, in most cases, state levels.
When it’s time to go to college, the money can be withdrawn tax-free to pay for qualified education expenses. These typically include tuition, books, supplies, and room and board at qualifying institutions.
If the original beneficiary does not need all the funds (for example, they receive a scholarship), the beneficiary can be replaced with another eligible family member without penalty.
However, if money is withdrawn for non-qualified expenses, part of the income from the withdrawal is subject to income taxes and usually a 10% penalty. Although the federal government does not set annual contribution limits, states can set lifetime contribution limits, which are usually quite high (often around $500,000 per beneficiary).
Starting this year , unused funds from a 529 plan can be rolled over to a Roth IRA for the account’s beneficiary without penalty. This new tax-free rollover rule, part of SECURE 2.0 , means you won’t have to worry about the current 10% profit penalty if you have any money left over.
Parent-owned 529 plans have a relatively small impact on eligibility for federal financial aid compared to other types of assets.
Finally, it’s worth noting that there are two types of 529 plans: savings plans (as described above) and prepaid education plans. Prepaid tuition plans allow you to pay for future tuition at today’s rates at participating colleges, but they are less common and have different rules.
Pros of 529 plans
The main benefit of 529 plans is their tax benefits. David Johnston, CFP and managing partner of Amwell Ridge Wealth Management, emphasizes that tax-free growth and tax-free distributions are “huge benefits that increase the longer the money is invested.” This tax-advantaged growth can significantly increase the value of your education savings over time.
Additionally, 529 plans offer unique benefits to scholarship recipients. As Johnston notes, “Funds equal to the scholarship received may be withdrawn without penalty.” This provision ensures that families are not penalized for their children’s academic achievements.
Additionally, Johnston notes that recent changes have expanded their usefulness: “Several years ago, provisions were added to allow up to $10,000 per year to be used for non-tertiary education expenses, such as elementary or high school.” Johnston further explains, “In addition to two- and four-year colleges and universities, funds can also be used for accredited vocational schools.” This expands the application of 529 funds beyond traditional four-year institutions.
Another lesser-known feature is the ability to change beneficiaries. Johnston states, “People also have little awareness that beneficiaries can be changed (i.e. funds from Child 1 can be transferred to Child 2’s account).” This flexibility can be especially beneficial for families with multiple children.
Cons and Limitations of 529 Plans
While 529 plans offer significant benefits, they have potential disadvantages. Johnston addresses a common problem: “The worst case scenario is that you have money left over—you saved too much.” In this case, you will be subject to the 10% penalty described above plus your ordinary income taxes on the profits.
However, he also offers alternatives to mitigate this problem: “You can leave the money for your grandchildren or use some of it to learn something new at a local college.” This highlights the long-term flexibility of 529 plans even if immediate educational needs are met.
Get the most from 529 plans
With rising tuition costs, strategic planning is critical. Johnston advises, ” Various calculators are available to help you determine the future cost of education, which varies greatly by state, out-of-state, public institution, or private school.”
Timing is also a factor: “Obviously, the earlier you start, the more you can reap the benefits of compounding.” It’s important to start saving money as early as possible so your investments have more time to grow.
Bottom line
529 prepaid college plans offer significant benefits to families saving for education, primarily through tax growth and flexibility. However, it is important to carefully consider your family’s specific circumstances and future educational needs when deciding how much to contribute. If you’re a parent looking to create that college savings vehicle, start looking for online tools that can help you compare what different plans offer by state. Here’s our guide to opening a 529 for your child .