If you are planning to help cover the cost of a child’s education someday, opening a 529 plan is often considered one of the best ways to start saving. That’s because a 529 college savings plan offers myriad benefits — it “allows you to invest in high-return assets, avoid taxes on the capital gains while in the account and then withdraw those earnings tax-free for qualified education expenses,” said Bankrate.
While this college savings vehicle can be a great fit for some, it’s not necessarily right for everyone. Here is what you need to know about the pros and cons of 529 plans to determine if this is the best savings option for you.
How do 529 plans work?
A 529 plan “is a tax-advantaged college savings account that can be used to pay for a beneficiary’s qualified education expenses, such as tuition or textbooks,” said Nerdwallet.
Originally, it was only possible to use 529 funds for post-secondary education costs, but now the money also can be used for “kindergarten through grade 12 as well as certified apprenticeship programs and qualified student loan repayments, up to a limit.” Additionally, said CNBC Make It, “beginning in 2024, beneficiaries will have the option to roll over some 529 plan funds tax- and penalty-free into a Roth individual retirement account (IRA).”
Money deposited into the account will grow “on a tax-deferred basis until it is withdrawn,” and “so long as the money is used for qualified education expenses as defined by the Internal Revenue Service (IRS), those withdrawals aren’t subject to either state or federal taxes,” said Investopedia. Additionally, it’s possible for the person funding the account to get a state income tax deduction on their contributions.
What are the benefits of a 529 plan?
A 529 can offer a number of upsides:
Money in a 529 plan “grows tax-deferred, which means it isn’t subject to capital gains taxes on an annual basis,” said Nerdwallet.Withdrawals are tax-free if the money is spent on qualified education expenses.Taxpayers may be able to get a state tax deduction or tax credit for their contributions to a 529 plan, depending on which state they live in.It is possible to change the account beneficiary, “which means if one child decides not to go to college or use the funds for a qualifying expense, you could redirect the funds to another family member,” said Nerdwallet.
Are there any drawbacks to 529 plans?
As mentioned, there are downsides to note as well:
Investment choices in a 529 plan “can be limited,” said Bankrate. For instance, “some state plans may offer only high-cost funds or a limited selection of funds.”If you use 529 plan funds for an ineligible expense, you’ll “incur a 10% penalty and owe taxes on any investment gains,” said CNBC Make It.You will also pay fees with a 529 plan, and those costs “may be higher than they otherwise would be if you had a wider selection of options — another part of the downside of limited investment options,” said Bankrate. Further, “as your money grows, you’ll be paying more each year for the fund.”Lastly, 529 plans “could reduce the scholarships and grants your child could receive,” said Bankrate. However, the impact could be lesser if it’s a parent-owned 529 plan as opposed to student-owned.
When does a 529 plan make sense?
“For many people, the advantages, including favorable tax treatment, will outweigh any downside, including potential penalties for early withdrawals or for using the money in a way that is not approved,” said Kiplinger.
That said, there are some circumstances where a 529 plan might not be the right move. For instance, said Bankrate, this might include if “you’re not sure if your child will attend college,” or if “you have investment experience and prefer to choose from a wide range of investment options rather than be limited to the investment strategy used in the state’s 529 plan.”
For anyone, however, “it’s worth paying attention to future changes, including possible federal government forgiveness of student loans and potential availability of free college education,” said Kiplinger, as this “may affect details relating to 529 accounts and their usefulness.”