Scariest College Savings Horror Stories and How to Avoid Them

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Kathryn Flynn

By Kathryn Flynn

October 28, 2019

With proper planning, a 529 plan can help you save for your child’s future and avoid student loans. But, college savings mistakes can haunt you. We asked a financial attorney to share her most terrifying college savings stories from her clients.

“The reality is that when you make a mistake with these accounts, very often the mistakes are not fixable,” says Leslie Tayne, founder of Tayne Law Group in New York. But, there are ways to plan ahead so that you don’t end up living one of these nightmares.

Using a retirement account to save for college

Some parents are tempted to use their employer-sponsored retirement plan to save for college, especially if the employer offers a matching contribution. But, there could be serious consequences to using a 401(k) plan or other retirement account to pay for college. 

For example, if you take an early withdrawal from a 401(k) plan your savings are subject to taxes and penalty. You also risk jeopardizing your financial security in retirement, since it will be difficult to replace the lost savings.

Most people don’t save enough for retirement. You should save a fifth of your income for the last fifth of your life, according to Mark Kantrowitz, Publisher of Savingforcollege.com. But, the average employee saves only 7 percent of their income in a qualified retirement plan.

Instead of using a retirement plan to save for college, Tayne suggests opening a 529 plan for your child. 529 plans offer tax-deferred investment growth and tax-free withdrawals when the funds are used to pay for college. Many states also offer a state income tax deduction or state income tax credit for 529 plan contributions. 

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Losing your college savings account after divorce

Most 529 plans do not allow joint ownership, and the funds are considered assets of the 529 plan account owner. That means in a divorce, the parent who is the account owner has the right to change the beneficiary or take a non-qualified distribution at any time.

Tayne recalls a client who assumed that an ex-spouse would take care of their child’s college savings, but the 529 plan account was never addressed in the divorce. When it was time to pay for the child’s college, there was no mention of the 529 plan and the funds were already gone. 

To prevent a nightmare like this from happening, Tayne recommends including the child’s 529 plan in the divorce or separation agreement, clearly stating:

  • The 529 plan must be used only for the children of the marriage
  • The amount of college costs that will be paid for with the 529 plan
  • The amount of the remaining college costs that each party is responsible for paying

Before a divorce, it’s also a good idea to make the child’s custodial parent the 529 plan account owner. Distributions from a 529 plan that is owned by a non-custodial parent can negatively impact financial aid eligibility, similar to distributions from a grandparent-owned 529 plan.

Losing your college savings to a scary stock market

Some families saving for college fell victim to a scary stock market. For example, 529 plan investments took a big hit when the stock market dropped by as much as 40% in 2008. Families who panicked and pulled their money out of 529 plans essentially locked in their losses and missed out on the recovery.

A better strategy is to select appropriate investments when you open a 529 plan and reassess your level of risk at least once a year as your child gets closer to college. If you prefer a “set it and forget it” investment strategy, consider an age-based 529 plan portfolio that starts out invested in stocks and mutual funds and gradually shifts toward more conservative investments like bonds and CDs as the child gets closer to college.

Having your college savings account levied by a creditor

Tayne also reminds families that college savings accounts may be susceptible to creditors. She has had clients with 529 plan accounts that were frozen because of a debt that went to collections.

“It doesn’t matter that the point of the account was to save for your kid’s college, the creditor does not care,” she said.

However, in some states 529 plans are protected from creditors. Creditor protection rules for 529 plans vary by state. For example, in some states only assets held in an in-state 529 plan are exempt from creditor claims, and some states limit protection from creditors to a certain amount. The rules may also be different if the 529 plan was set up as a custodial 529 plan account.

Parents who are having debt issues should check their state’s rules regarding creditor protection for 529 plan assets. If your state does not exempt 529 plan accounts from creditor claims, Tayne recommends moving the funds into a different account. One option is to give the funds to a trusted friend or relative who can open a 529 plan account in their name and name your child as the beneficiary.

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