What Are the Pros and Cons of Using a 529 Plan?

Paying for college is a major expense. If you’re thinking about opening a 529 plan for a child or grandchild, it’s important to understand 529 plan rules and how they work.

This list of pros and cons of 529 plans will help you make the right choice for your child’s college savings. 

Pros and Cons of 529 Plans

Advantages of Using a 529 Plan to Save for College

Let’s take a look at 529 plans’ pros and cons, starting with their advantages.

Tax benefits

Investing in a 529 plan has a range of tax benefits. 529 plan investments grow on a tax-deferred basis and distributions are tax-free when used to pay for qualified education expenses, including college tuition and fees, books and supplies, some room and board costs, up to $10,000 in K-12 tuition per year and up to $10,000 in student loan repayment per beneficiary and per sibling.

In most cases, states exclude qualified 529 plan distributions from taxable income, and many states offer a state income tax deduction or state income tax credit for 529 plan contributions. 529 plans are the only college savings plan to offer state tax benefits. 

States may have residency requirements for tax benefits, but families are not restricted to using their home state’s college savings plan. An exception may be if they are using a prepaid tuition plan. 

Low Maintenance

A 529 plan account can be opened online or through a licensed financial advisor. Families who prefer to “set it and forget it” can select an automatic investment plan linked to a bank account or payroll deduction plan. The ongoing investment management within a 529 plan is handled by the program manager.

High Contribution Limits

Unlike other savings plans, such as a Roth IRA or Coverdell Education Savings Account, 529 plans have no annual contribution limits and high aggregate limits. Maximum aggregate limits vary by state, ranging from $235,000 to $529,000.

529 plan contributions are considered completed gifts to the designated beneficiary for tax purposes. In 2022, up to $16,000 qualifies for the annual gift tax exclusion. There is also an election to contribute as much as $80,000 in one year without generating a taxable gift if the contribution is treated as if it were spread over five years.

Favorable Financial Aid Treatment

When a dependent student’s parent or a dependent student owns a 529 plan it is reported as a parental asset and has a relatively minimal effect on financial aid eligibility. Distributions from parent- and student-owned accounts are not counted as income on the Free Application for Federal Student Aid (FAFSA).

Flexibility

529 plans offer the same benefits for all families, regardless of their household income or the amount they contribute. You can invest in almost any 529 plan, no matter where you live or where you child will attend college.  

Disadvantages of Using a 529 Plan to Save for College

Along with the benefits, there are also a few disadvantages of 529 plans.

Penalty for Non-Qualified Withdrawals

Non-qualified distributions are subject to income tax and a 10% penalty on the earnings portion of the distribution. However, there are exceptions to the penalty if the beneficiary gets a scholarship, attends a U.S. Military Academy, dies or becomes disabled.

State Income Tax Recapture

If a 529 plan account owner does a rollover into another state’s 529 plan, any state income tax deductions and credits previously claimed may be subject to recapture, and the earnings portion of the outbound rollover may be added back to state taxable income.

Limited Investment Choices

A 529 plan account owner must select from a menu of investment options offered by the 529 plan. This typically includes static investment portfolios that aim to achieve a targeted level of risk, individual fund portfolios and age-based portfolios that automatically shift asset allocation as the beneficiary gets closer to college.

Fees 

The more families pay in 529 plan fees, the less they are able to save for college. Direct-sold 529 plans are less expensive than advisor-sold 529 plans, but expenses can also vary among 529 plan portfolios. It’s important to research your options and find a low-cost 529 plan option that meets your college savings needs.

Ownership rules

The 529 plan account owner, not the beneficiary, has legal control of the money in the account. The account owner can easily change the beneficiary at any time, or worse, they can take a non-qualified distribution and liquidate the plan. This might become an issue if a parent is depending on a grandparent or other relative’s 529 plan to pay for their child’s college education. 

Is a 529 plan right for you?

To choose the best option for you, there are a few things you should consider when weighing up 529 plan pros and cons:

• Are you planning to use the funds exclusively for education savings?
• How much do you need to save for college, grad school, K-12, or apprenticeships?
• What state do you live in?

529 plans can only be used to fund education expenses, otherwise, you’ll face penalties. On the other hand, 529 plans have high contribution limits, offer significant tax benefits, and have a limited impact on financial aid. Depending on the state you live in, you may also have access to additional state tax benefits, but this is limited to certain states.