Why 529 Plans Are A Bad Idea

Many consumers consider 529 plans as a secure financial vehicle for saving for college due to their tax advantages and flexibility, but there are reasons why some believe they may not be the best choice. Below is an exploration of why 529 plans could be considered a bad idea for some families.

Understanding 529 Plans

Before addressing the downsides, it's essential to understand what a 529 plan is:

• Educational Savings Plan: A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. Formally known as “qualified tuition plans,” they are authorized by Section 529 of the Internal Revenue Code.

• Two Types: There are two main types of 529 plans:

  1. Prepaid Tuition Plans: These allow the pre-purchase of tuition credits at current rates for future use.
  2. Education Savings Plans: These involve investing in various portfolios to grow savings over time.

Limitations on Usage

A significant limitation of 529 plans is their usage restrictions:

• Qualified Expenses Only: Funds withdrawn from a 529 plan must be used for qualified educational expenses, including tuition, fees, books, supplies, and equipment required for enrollment or attendance. Additionally, room and board are covered if the student is enrolled at least half-time.

• Non-Educational Penalties: If the funds are used for anything outside the qualified expenses, you may face a 10% federal tax penalty on the earnings portion of the withdrawal along with ordinary income tax. This limitation can be cumbersome if a child receives a scholarship or decides not to attend college.

Financial Aid Impact

One concern for many families is how a 529 plan affects financial aid eligibility:

• Considered Parental Assets: 529 plans owned by students or their parents are considered parental assets on the Free Application for Federal Student Aid (FAFSA). They are usually assessed at a maximum of 5.64% when determining a family's expected contribution, which can reduce a student's eligibility for need-based financial aid.

• Reduction in Aid: In cases where families are on the margin for qualifying for aid, every dollar in a 529 plan can slightly reduce the amount of aid offered, which could lead to increased student loan debt.

Market Volatility and Investment Risks

Like any investment, 529 plans carry market risks:

• Exposure to Market Downturns: The value of a 529 plan depends on the performance of the investments in the account. During economic downturns, these accounts can significantly decrease in value, potentially wiping out years of savings.

• Prepaid Plans Not Immune: While prepaid plans eliminate market risks on tuition rates, they often do not cover room and board or other educational expenses, and may hedge poorly against inflation or rapidly increasing tuition costs.

State Oversight and Fees

State governments sponsor 529 plans, leading to variability and potential downsides:

• Differing State Benefits: The tax benefits and fees associated with 529 plans can vary significantly between states. Some states offer tax deductions or credits for contributions, but only if you invest in your home state's plan. This introduces a complex decision-making process when choosing plans.

• High Fees: Some plans come with high administration fees and investment management costs, eating into the potential earnings. It's essential to compare plans and their associated fees thoroughly, which may be time-consuming and complex for the average investor.

Lack of Flexibility

529 plans might not offer the flexibility some families need:

• Limited Beneficiary Changes: While beneficiaries can be changed to another family member, this doesn’t cover all situations. Families who face sudden financial hardships or decide to pursue non-traditional educational paths may find these restrictions burdensome.

• Dependent on Education System: The 529 plans are heavily reliant on the traditional education system. As more educational paths develop, such as apprenticeships and online courses, the scope of "qualified education expenses" may not cover all meaningful educational opportunities.

Poor Comparisons with Other Savings Options

Examining alternatives highlights potential weaknesses in 529 plans:

• Roth IRA Benefits: A Roth IRA allows after-tax contributions and tax-free withdrawals for retirement. It also provides more flexibility, as funds can be used for any purpose in retirement, and contributions (not earnings) can be withdrawn at any time without penalty for college costs.

• Flexible Investment Accounts: Regular brokerage accounts, while lacking tax advantages, offer no restrictions on how the money can be used, providing an escape clause if educational expenses change.

• Coverdell ESAs: A Coverdell ESA offers similar benefits to a 529 but with the added advantage of being usable for K-12 expenses. However, it comes with lower contribution limits and income restrictions.

Overlooked Misunderstandings and Questions

When discussing the disadvantages of 529 plans, it's also prudent to cover common misconceptions:

FAQ

Can a 529 plan account be used for international universities?

Yes, funds can be used at any U.S. post-secondary institution and many international universities, provided they are eligible to participate in a student aid program administered by the U.S. Department of Education.

What happens to the money if my child doesn’t go to college?

You can change the beneficiary to another eligible family member or withdraw the funds, understanding that non-qualified withdrawals incur taxes and penalties.

Is a 529 plan supported by the federal government?

Federal benefits primarily come in the form of tax advantages rather than direct support. Each state sponsors their versions of 529 plans.

Potential External Resources for Further Reading

For those considering 529 plans, numerous reputable organizations and publications offer valuable insights:

• Morningstar: Offers annual ratings and reviews of 529 plans based on investment options and fees.
• College Savings Plan Network: Provides detailed information on each state-sponsored plan.

In conclusion, while 529 plans offer considerable benefits for specific circumstances, their drawbacks, limitations on funds' use, potential impacts on financial aid, market exposure, state variability, and less flexibility compared to other savings vehicles often make them undesirable for some families. A well-informed decision, considering these factors against your family's financial situation and educational goals, can aid in choosing the most suitable option.