When it comes to saving for their children's college education, many parents are attracted to 529 plans because of the built-in advantages that make socking away enough cash for college easier.
Named for the section of the Internal Revenue Code that established these plans in 1996, 529s offer parents the ability to contribute funds to state-operated investment plans that allow those funds to grow tax-deferred. Then, once a student is ready to pay for college, qualified withdrawals are tax-free. Additionally, some states offer tax breaks on the money contributed to 529s during the year.
Despite those benefits, there are some possible drawbacks to using 529 plans to save for college. Early awareness of these four potential problems can give parents the opportunity to minimize or prevent them altogether.
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1. High fees: State-sponsored 529 plans often come with higher fees than other savings and investment vehicles, says certified financial planner Lauren Klein of Newport Beach, California's Klein Financial Advisors. And because 529s typically house relatively conservative investments, high fees can all but wipe out an account's growth.
Broker fees are one source of these additional costs, and Klein says that they are at least 1 percent of the total asset, if not more. That may not sound like a lot, but it can add up over the long term.
"It's very easy for parents to purchase a plan independently -- which makes paying that 1 percent or more in broker fees an option that should certainly be avoided," she says.
For parents interested in purchasing a plan without the assistance of a broker, Klein recommends savingforcollege.com as a great way to compare plans side by side. On the site, all plans are listed as "direct sold" or "broker sold." The website also provides details on the overall costs associated with 529s, giving parents the knowledge they need to choose plans with low fees.
Klein says she likes Nevada's Vanguard 529 Plan because it is one of the more affordable plans available. "What makes this plan, in particular, a great value is that not only are the funds inside the plan selected for their low cost, but Vanguard's investment costs are lower than others as well," she says.
2. Limited investment options: With 529 plans, one big advantage for less financially-savvy parents can also be a drawback for some families.
The best way to ensure adequate earnings in a 529 plan is to build the right investment portfolio within the account that will balance risk and growth potential. The problem, says Stu Caplan, director of portfolio management at Apex Financial Advisors in Yardley, Pennsylvania, is that some plans don't provide an adequate selection of investments for parents to choose from.
Fortunately, parents are able to choose 529 plans operated by other states, so they can shop around for the best option. Like Klein, Caplan likes the Vanguard plan, as well as Virginia's College America 529 plans. Both, he says, have portfolio funds that simplify the selection process for less-than-savvy parents.
"If you need to see rapid growth, stick with an aggressive fund option, but know that more growth expectation comes with added risk," he says.
[Search for plans with the U.S. News 529 Finder.]
3. Impact on financial aid eligibility: Many parents use 529s as one part of a larger plan to cover college expenses -- a plan that may also involve financial aid. And, in that case, maintaining a student's financial aid eligibility is important when considering who should be listed as the owner of the 529.
"A 529 account owned by a parent is reported on the federal financial aid application as a parental asset," says Dave Buckwald, CEO and senior partner at Atlas Advisory Group in Cranford, New Jersey. "Parental assets are assessed at a maximum 5.64 percent rate in determining the student's expected family contribution. But, if the 529 is owned by the student, that assessment rate is a much higher 20 percent."
So, when owned by a student, a 529 creates the impression of higher student assets and can greatly impact eligibility for grants and loans.
"Depending on your circumstances, this is an important consideration when deciding who should own the plan," says Buckwald. "The best solution is to speak with a financial advisor to be sure the best plan owner is selected."
4. Taxes and penalties: The most significant benefit of 529 plans -- the fact that funds are tax-advantaged -- is only available on one condition. If funds are not used for approved educational expenses -- like tuition, room and board, and supplies and equipment that are required for enrollment -- withdrawals are subject to income taxes and a 10 percent penalty.
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"This is generally not a problem except in cases where the kids don't go to college or college costs less than expected," says Jason Lina, certified financial planner and lead advisor at Resource Planning Group in Atlanta.
Parents should carefully evaluate all expenses to ensure that they are qualified for 529 fund use, and in the case of any surplus, Lina suggests gifting the account to another family member so that none of the tax benefits are lost.
"Plan assets may be used to pay for a European culinary course offered by an accredited institution, as an example," Lina says. "There is not a full-time student requirement, and all kind of trade schools are eligible. There are golf academies, horticultural classes at community colleges and other opportunities for even seniors to utilize 529 assets. I'd recommend individuals check with their tax advisor before using a 529 to go on a European vacation, but the opportunity seems to exist."
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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