Have you started a 529 plan yet? If you’re a parent, you might not have enough fingers to count the number of times others have asked you that question.
But the faster you can start planning for the cost of college, the better. In fact, parents with as little as $500 in a 529 college savings plan are four times likelier to see their child graduate from college, according to The Education Plan.
With that said, a 529 plan isn’t the only option for parents paying for college. Check out the following pros and cons of using a 529 plan.
5 pros of paying for college with a 529 plan
You can save up for your child’s future education expenses over time using 529 plans. These tax-advantaged plans often put you in the driver’s seat as a manager. Here are the specifics.
1. You have options when selecting a plan
There are two basic types of 529 plans:
- Prepaid tuition plans: You lock in current tuition rates at in-state public institutions. If your child decides to go to a private or out-of-state institution, you might receive only a small return on your original investment.
- Savings plan: You contribute regularly and rely on the account’s earnings to grow. You take on more investment risk but give your child the opportunity to use the funds at public and private schools nationwide.
2. You can shop around from state to state for a savings plan
Once you figure out which 529 plan is right for you, you can shop around. You don’t have to be a resident of a state to participate in its saving plan.
When choosing a savings plan, you might prioritize a state that caters to your investment style. You might also be tempted to stick with your home state’s plan if it offers a tax credit or other benefit.
In Colorado, for example, the CollegeInvest Matching Grant Program gives eligible residents up to $2,000 over five years when they open and contribute to a 529 plan.
3. You might not have to pay taxes on the plan’s earnings
If you select a 529 savings plan, you’re tying your contributions to the stock market. Over an extended period, your contributions should grow with the market.
A big pro of the savings plan is that you don’t pay federal or — in most cases — state taxes on that growth as long as your child uses the funds for qualifying education costs. Eligible costs include tuition, books, and room and board. If the expense doesn’t qualify, a withdrawal from the plan would be taxed and subject to a 10% penalty.
One exception is if your child earns a scholarship or fellowship or employer-based tuition assistance. You could withdraw an equal amount from the account without facing the 10% penalty.
4. It’s becoming easier to use the funds for pre-college education
You could use 529 plans to pay for tuition, fees, books, and room and board. As of 2009, you could also use the plans to pay for your student’s computer equipment and internet access.
But until more recently, those expenses had to be related to paying for college. The Tax Cuts and Jobs Act passed by Congress in December 2017 allows you to use up to $10,000 of plan savings annually for private education between kindergarten and high school.
5. You could switch beneficiaries without penalty
You might be concerned that your child will skip college down the road. That could leave you with a full savings plan but no one to use it.
Luckily, you can change the beneficiary of your 529 savings plan without suffering tax consequences. Maybe a younger child in the family could use the funds or you’re considering going back to school. You could also roll over one 529 plan balance into another plan if one of your children doesn’t need the money.
5 cons of paying for college with a 529 plan
Here are five potential hang-ups that might affect your decision to open up a 529 plan.
1. There are significant upfront costs
You’re paying for college credits out of pocket and in advance with a 529 prepaid tuition plan.
In Virginia, for example, you would pay $8,825 per semester for your newborn to eventually attend a four-year public school. If you wanted to cover four years of college, you’d make a one-time payment of $70,600 or monthly payments of $545.
Although 529 savings plans are more affordable options, some have minimum contribution requirements. In Arkansas, for example, you’d need to make an initial contribution of at least $500 to open an iShares 529 Plan. Other states require an initial deposit of at least $1,000, according to Saving for College.
In most states, you might also be required to make minimum subsequent contributions between $10 and $50 each month.
2. Your child’s need-based aid could be reduced
If you start a 529 plan for your child, you should know that it could affect their access to federal student aid.
That’s because your family’s full financial picture is considered when you and your student complete the Free Application for Federal Student Aid (FAFSA). Your 529 savings could increase your student’s Expected Family Contribution (EFC), which is calculated using the FAFSA.
The EFC is the Department of Education’s way of estimating how much you can afford when paying for college. The higher your EFC, the fewer federal grants, work-study opportunities, and subsidized loans your child could receive.
3. There are penalties for noneducational withdrawals
You’ll want to avoid using a 529 plan for ineligible expenses, such as transportation to school and student loan payments.
Remember that if you make a withdrawal to cover an ineligible expense, it’ll be considered income. The IRS will tax you on it. Plus, you’ll be subject to a 10% fee.
4. There are also penalties for ill-timed withdrawals
You might know you have a tuition bill coming down the pike and withdraw the amount from your savings plan without a second thought.
But think twice. A qualified education expense should occur during the same year of the withdrawal. To be safe, talk with your 529 plan provider before making a withdrawal for a seemingly approved expense.
Also, be aware that if you withdraw more than $14,000 in a year to pay for tuition, that could subject you to the IRS gift tax.
5. You have less say over your investments
When you sign up for a savings plan, you’re really signing up with the plan manager selected by your state. Financial services company TIAA, for example, manages 529 plans in many states, including California, Georgia, and Michigan.
If you’re a savvy investor, you might be disappointed by the lack of control you or your family financial advisor could have in managing the plan. You can only change how you’re allocating your plan’s balance up to two times per year, for example.
You also must choose from preset investment options. In Oregon, for example, TIAA offers you four different portfolios of varying risk levels. One portfolio makes investments based on your student’s age. The closer your student is to college, the more conservative the portfolio becomes.
But unless you’re a beginner investor, you might miss having up-to-the-minute flexibility in where you’re investing your money.
Weigh the pros and cons before paying for college with 529 plans
At their core, 529 prepaid tuition and savings plans give families a leg up in paying for college.
With a prepaid tuition plan, you can lock in today’s tuition rates even if your student is a decade or longer from enrolling. And with a more traditional savings plan, you can access stock market growth with small monthly contributions.
Weigh the pros and cons and review your family situation to make the most of a 529 plan. Even if a 529 plan sounds like the perfect solution, examine ways to save for college without relying on one. Whichever savings vehicle puts you and your future college student in the best position is the one you should choose.