Loading the player...

Investing in your child’s education is one of the most important things you can do for your child. A 529 plan enables you to start saving early – the earlier the better - so you can allow the money you invest to make more money for you and your child. Since the new tax law, you can also put money in a 529 to save for K-12 education costs (see How New Tax Changes Promote 529 Investments), though a number of experts caution that college savings is its best use.

However you use it, there are some pitfalls you must avoid if you want that investment to pay off when your child is ready to go to school. We look at the top seven mistakes that could trip you up.

1. Not Considering Your State Plan First

The biggest mistake you can make is picking the wrong plan. As you begin your research start with your state plan first to understand what it offers. Every state offers at least one 529 plan, but they are not all created equally. One of the biggest advantages is that your contributions in more than 30 states can result in a tax credit to lower your annual state bill. 

If you live in one of these five states – Pennsylvania, Arizona, Maine, Kansas or Missouri – you can invest in any state’s plan and still reap the tax benefits they offer.

Even if your state offers tax benefits, be sure the investment options match the types of investment choices you want to make. A good place to start comparing 529 options on the internet is SavingforCollege.com and its ranking of the top performing funds. 

2. Failing to Understand Your State’s Guarantee

Some states offer prepaid tuition plans, but not all tuition guarantees are the same. Some states offer you the opportunity to lock in tuition fees provided your child chooses to go to an in-state school. But beware, many states that make this guarantee don’t guarantee your returns. If your returns fall short, there may not be enough money even at the guaranteed tuition rate.

If a tuition guarantee is important to you, the only states you can count on are: Florida, Massachusetts, Mississippi or Washington. Otherwise there is no guarantee if tuition growth outpaces the growth of your investments. Be sure to read the fine print. 

3. Disregarding Fees and Expenses

As with any investment, fees and expenses can have a negative impact on the success of your investment. Research done by the Financial Research Corporation, a major mutual fund research organization, found that the average annual fee for a 529 is 0.69%, if purchased directly from a state. But 529s purchased through brokers average 1.17%. 

That difference in fees can really add up over time. If you invest $10,000 on the day your child is born, it will be worth $39,246 on his or her 18th birthday if you assume an 8% return with 0.1% internal fees. If those fees are 1.1%, the same 8% return will only grow to $32,746.  "That's free money you're just leaving on the table that could be spent on your child's education," says Brian Preston, a CFP for Preston & Cleveland Wealth Management in McDonough, Ga., and host of the Money Guy.

4. Paying Avoidable Penalties to Switch Plans

If you start out in a 529 and find you’ve made a mistake, you can switch plans, but do so very carefully to avoid penalties and taxes. You can only make one penalty-free rollover into a new 529 in any 12-month period. The only exception to this rule is if you want to change the family member who will benefit from the plan. For example, suppose you started a 529 for each child at birth. One of your children won a full scholarship and won’t need the money. You can roll over the funds into the name of another child without worrying about the once-in-12-months rule.

The best way to avoid any risk of penalty or taxes is to work with the new plan administrator to coordinate the transfer. There are other fees you must watch out for, too: Some states have a recapture tax on past tax deductions if you do an out-of-state rollover. Others charge fees to provide rollover services. So be sure you ask about all possible fees if you are thinking of changing 529 plans. For more, see How and When to Switch Your 529 Plan.

5. Withdrawing Funds Incorrectly 

When you’re ready to start using the funds for your child’s education be careful how you withdraw those funds. The money can only be spent on qualified higher education expenses (QHEE).

If you don’t follow the rules, you can face unnecessary taxes and penalties. Here are two key things to consider:

– If you pull out money before your child enrolls in college you will pay taxes on the money, including an additional 10% penalty on the portion that constitutes earnings (not your original deposit). So don't remove the money before your child enrolls and then only take out what is needed to cover the child's QHEE.

– Be sure to consider all grants and scholarships when calculating how much money you can take out in any one year. You must subtract money your child receives from other sources before taking out 529 funds. If you take out too much, the excess will be considered taxable income and you will have to pay that additional 10% penalty on the earnings portion of the money.

If your child doesn’t need the money, thanks to scholarships and grants, you can transfer the funds to another family member without taxes or penalties – or save it in the fund for the child's future use, such as graduate school.

6. Covering Non-qualified Expenses

Some college costs are not qualified expenses for 529 money. For example, you can’t pay off student loans or pay transportation costs with the funds. If your child wants to live off campus, ask your college for room-and-board expenses that would be typical if they lived on campus. You can only use 529 money towards off-campus housing that does not exceed the on-campus costs.

7. Delaying Your Contributions

As with any investment, delaying your contributions is always a big mistake. For example, $1,000 deposited when your child is born will grow to $3,996 in 18 years at an interest rate of 8%. Wait until your child is 10 and that $1,000 has only eight years to grow and will amount to just $1,850 by the time your child is ready for college.

The Bottom Line

Start saving for college as soon as your child is born. You, as well as other family members, such as grandparents, can make contributions to the 529. Carefully research your options, but if you make a mistake you can switch plans at a later date. For more information, see 5 Secrets You Didn't Know About a 529 Plan and  529 Risks to Take (Or Not). Also check out our 529 Plan Tutorial.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.