The relentless increase in the cost of higher education has left millions of parents scrambling to find ways to fund their kids' college tuitions and other fees. At a whopping 6% above the rate of inflation, the rise in the price of a higher education looms over America like a tidal wave that threatens to wash away the savings of much of the middle and lower class. In an effort to combat this trend, the government has created several types of savings accounts designed to fund higher education. The most popular type of account is the 529 plan, a tax-deferred state-sponsored plan with high contribution limits. However, this plan may not always be the best option for everyone who is seeking a funding vehicle for higher education. (For related reading, also take a look at Choosing The Right 529 Education Savings Plan.)
TUTORIAL: Budgeting Basics
How 529 Plans Work
These programs offer a wide range of investment choices inside the plan, in the same manner as 401(k) plans. The funds inside these plans can then be withdrawn tax-free, as long as they are used for qualified educational expenses, such as tuition, books, lab fees and room and board. Furthermore, contributions are usually deductible on the state tax return of the donor, provided that he or she lives in the state that sponsors the plan receiving the funds. One of the biggest advantages of 529 plans is that the donor retains control of the funds even after the beneficiary reaches the age of majority, thus preventing the beneficiary from being able to withdraw the funds for other reasons without the donor's permission.
Issues to Consider Before Funding a 529 Plan
Forfeiture of Funds
If the beneficiary for whom the plan is created decides not to pursue a higher education after high school, then the donor can either transfer the plan to someone else, such as another friend or relative, or else withdraw the money. But 529 Plans levy a 10% early withdrawal penalty on any distributions that are taken out for any reason other than qualified educational expenses. For example, if the beneficiary of the plan demands that the donor take out the money so that the beneficiary can buy a sports car, then he or she must pay this penalty on the entire distribution. The amount withdrawn will also be taxed as ordinary income to the recipient.
Costs and Fees
Although the range of fees varies widely between plans, many plans levy sales charges and fund management fees that can make a material difference in the value of the account over time. Alternative investments, such as savings bonds, do not have this type of expense.
Investment Risk and Time Horizon
The subprime meltdown of 2008 has shown some chinks in the armor of these programs, when the value of many of the accounts in these plans dropped by as much as 25%. Of course, more conservative investment options are available in many of these plans, but those seeking guaranteed return of principal may be better off buying U.S. EE savings bonds or treasury securities.
TUTORIAL: How To Manage Credit And Debt
Another key drawback that comes with owning one of these plans is that they will reduce the amount of financial aid for which the student and his or her parents can qualify, because they are counted as assets on the FAFSA form. Therefore, donors should consider this issue before putting a large amount of money into the plan. Many times it is prudent to allow a grandparent or other trusted friend or relative act as the donor in order to avoid having to list it as an asset on the FAFSA. If the receipt of financial aid is a material consideration, then alternative funding vehicles such as cash value life insurance may be more appropriate.
The Bottom Line
There are many issues to consider when choosing how to save for college. 529 Plans may not always be the optimal funding vehicle for every donor or family. For more information on 529 Plans, consult your high school financial aid officer or financial consultant. (For additional reading, also see A 529 Plan Fit For An Ivy League Education.)