Most people begin looking into tax-advantaged 529 plans shortly after the birth of their first baby. But it can be very daunting to a first-time saver because of the seemingly 529 different options, rules, and regulations that go along with these funds. The 529 nickname comes from Section 529 of the Internal Revenue Code, which allows contributions to grow tax-free if used for qualified educational expenses. In this article, we explore the basics of these plans and outline some of the biggest risks you should avoid.

Key Takeaways

  • Don't put off putting your money in a 529 plan.
  • Age-based funds adjust their investment strategies based on when you plan on making withdrawals, so you can ride out waves in the market.
  • Consider the pros and cons of prepaid tuition savings plans.
  • Don't spend the money on non-qualified expenses.
  • You can comparison shop between plans—you aren't obligated to invest in your state 529.
  • Be a good saver.

What Is a 529 Plan?

A 529 plan is just one way to accumulate tax-advantaged savings for education expenses. You may also choose to investigate other savings options including Coverdell education savings accounts, Uniform Gifts to Minors accounts, Uniform Transfers to Minors Act accounts, tax-exempt municipal securities, and savings bonds.

If you live in one of 34 states or the District of Columbia, you can take advantage of your state tax deduction for 529 contributions in addition to the federal benefits. These deductions range from $10,000 per contributor for Oklahoma and Mississippi up to Pennsylvania’s double whammy—$15,000 per contributor per beneficiary.  

Thirty-four states and D.C. offer residents tax deductions for 529 plan contributions.

The more closely you focus on finding the best way to accumulate the money your baby will need for future education expenses, the more complex the decision becomes. It’s tempting to shuffle brochures into your bottom desk drawer and bookmark the websites to worry about later. This is the first and biggest risk of all education savings plans.

Risk # 1: Doing Nothing While Time is Most on Your Side

College costs clock in with far higher rates of inflation than the overall economy. FinAid.com’s College Cost Projector puts the tuition-inflation rate at 7.0%. By contrast, the U.S. Inflation Calculator, using the current Consumer Price Index (CPI), puts the overall economy’s inflation at 2.3% for the 12 months ending in December 2019.

The return on a regular savings account significantly lags behind the tuition inflation rate. The annual percentage yields (APYs) for the best high-yield savings accounts ranged from about 0.9% to 1.3% as of August 2020. You’re going to need those tax advantages to boost the return on what you put away. Because the power of compound interest increases with time, the sooner you start, the better.

Tip

Don’t let paralysis of analysis rob you of the benefits of an early start. You can usually open an automatic deposit payroll plan through your employer with as little as $25. Consider one of the following plans.

Savings Plans

The savings plan is really an investment plan supervised by a state office whose plan you contribute to—generally the state treasurer or comptroller. The state usually subcontracts plan operation to a financial service such as Upromise, JP Morgan Asset Management, or Vanguard. The money you contribute is invested through one or more state funds, much like a mutual fund, and each state has its own rules.

529 savings plans were originally designed to pay only for post-secondary education costs. But in 2017, the Tax Cuts and Jobs Act (TCJA) expanded the plans to cover certain costs associated with K to12 education. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 expanded 529 savings plans further, allowing participants to use the funds to pay for certain expenses associated with qualified apprenticeship programs and to pay for up to $10,000 of student loan debt.

Tuition Plans

If you're scared of the stock market’s peformance, you may find the other, smaller category of 529s more attractive. A prepaid tuition 529 plan means that rather than having your savings subject to the uncertainties of the stock market, you use today’s dollars to buy tuition credits to be used for your children’s college educations. They are like vouchers. Room and board is not covered in 529 prepaid-tuition plans, though, so part of your cash still should go into a 529 savings plan for that purpose.

Each of these plans subjects you to some built-in risk. Managing funds in your 529 plan requires choosing whether to save in one or both plans and thinking your way through the challenges of handling them.

Risk # 2: The Market Falls When You Need the Cash

Choosing the savings-plan route means you're betting that your fund's investment portfolio will do well enough to raise the money you need. The Big Bad Wolf of savings-plan management is overall market volatility, more than the poor performance of a particular fund. The other challenge is how much time you are willing to spend managing that money.

Tip

One place to get some help is through age-based funds—a category usually offered along with more growth-oriented options. Also called age- or time-targeted, these managed funds adjust their investment strategy based on when you plan to withdraw money to pay for college. Fund investments tend to be more aggressive or higher-yielding if you have a longer lead time. The sooner you need it, the more conservative the investments, ensuring some money even if the market falls. This targeted strategy does not remove all risk, but it does minimize risk intelligently and automatically.

But watch out for fees. Since they are managed funds, many have very high fees. Here's where to find reports on which 529 funds have the lowest fees on savingforcollege.com. Search further for age-based funds and you'll find they aren't the least expensive type. Choosing them involves a tradeoff.

Risk # 3: With Prepaid Tuition, One Size Does Not Fit All

Let’s say you buy into the concept of tomorrow’s tuition at today’s prices. You see it as an advantage that you don’t have to manage the growth of the money, the state does it—just like a pension plan. But not only is the number of states offering prepaid tuition plans shrinking, but some plans are also under-funded—again, just like pension plans.

Similarly to paying points upfront on a mortgage, you usually pay a premium over today’s actual prices to purchase prepaid tuition credits, but it can still seem like a pretty good buy. The promotional language is usually very persuasive, yet as Forbes reported, most states do not actually guarantee that your prepayment will cover the actual college tuition for your child when the day comes. You may actually end up with sizable extra assessments and new fees to cover funding shortfalls, especially in states that slash educational costs. And then there’s the delicate matter of school choice and student performance. How likely is it that all your kids will want to go to the college you pick for them? How sure can you be that they will all get into—or through—that college?

The downside of prepaid plans is their lack of flexibility. For instance, the student must attend the school at least half-time for the credits to be applied. It’s far from easy to transfer prepaid tuition credits to other schools even in the same state, and you can rarely redeem them or get close to full value except at the designated institution. The plans have “a history of difficulties,” according to Reuters.

Tip

Putting part of your family’s college money into a prepaid tuition plan may indeed turn out to be the best buy, but preserving flexibility by putting the rest into a 529 savings plan savings can be an important hedge. Also helpful is the ruling that the beneficiary or beneficiaries of a 529 plan can be changed once a year, as long as you keep it in the family. The IRS calls this a rollover and is very specific about who qualifies as family:

  • Spouse
  • Brother, sister, stepbrother, or stepsister
  • Father, mother, or ancestor of either
  • Stepfather or stepmother
  • Son or daughter of a brother or sister
  • Brother or sister of father or mother
  • Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
  • The spouse of any individual listed above
  • Son, daughter, stepchild, foster child, adopted child, or a descendant of any of these
  • First cousin

Risk # 4: You Spend 529 Money on Non-Qualified Expenses

Your contribution is not irrevocable. As the owner of the account, if you need to repurpose the money in a 529 savings fund for something that’s not education-related, you can do so. There are some penalties. You’ll lose the tax benefit and must repay any state tax deductions based on contributions plus a 10% federal penalty on earnings. All the same, you can reclaim the principal—it still belongs to you. Having the financial penalty in place is a good psychological barrier to keep you living within the restrictions of the 529 rulebooks, but sometimes priorities must change. 

Tip

Another layer of protection for college funds is to have an adequate emergency fund readily accessible—usually calculated as enough to cover three to six months of normal expenses. Use that before breaching your 529 plan.

Risk # 5: The State 529 Fund You Pick Underperforms

Well-diversified holdings in the 529’s investment funds offer some protection against bad markets and past performance may give you some guidance on which investments to choose. But the most control over your earnings comes from scrutinizing the fees within your 529 plan.

The larger management fees and fund-overhead charges of brand-name operators can cost you as much as a full point, or even slightly more, off your investment return rate. Many are charged upfront before your money goes to work. They may sound small—a quarter-point here or a half-point there—but their inroads add up to serious money over time.

Tip

You aren't obligated to use your home state’s 529 savings options. Comparison-shop for both direct-sold funds and private funds. Although states are the only ones that offer prepaid tuition plans, private financial firms and college consortiums offer qualified 529 savings plans.

An independent financial planner can evaluate the lowest-fee, direct-sold funds for you and keep on top of deadlines and deductions. You can mentally write off the fee you pay the planner as necessary overhead, and you'll probably see actual cash savings over the long run.

Risk # 6: You're Not Good About Saving Money            

You are probably the biggest risk to your children’s chances of graduating without crippling education debts, not to mention to your own comfortable retirement, and possibly to your long-term self-respect and family harmony if you can’t get a grip on saving money. There's a strategy that could make the process a little more palatable, especially if you're more likely to buy a lottery ticket than park spare dollars in a bank.

The new savings vehicle is a prize-linked savings account. Your minimum deposit doubles as a qualified ticket in a lottery or sweepstakes that gives randomly chosen winners a cash reward, usually from a long list of small prizes and a shortlist—maybe even just one per month—of flashy, big-number prizes. Credit unions in a growing number of states are setting up these accounts, and federal legislation is in the works.

Your deposit stays in the savings account, but you can walk away with extra cash from the prize. One prize-linked savings group, Save to Win, already has 142 participating credit unions and is honing its offerings to find the best magic formulas to attract and reward previously intractable non-savers. PBS NewsHour called it “a lottery where you can’t lose.”

That’s true, although if you don’t win a prize, your savings in the plan don't accumulate the earnings growth of conventional 529 plans. The best solution is simple—don't leave them there.

Tip

Roll over the balance into a qualified 529 plan for the beneficiary of your choice at least after a year. After that, you can either start making additional deposits directly into your new 529 or funnel them through the prize-linked savings account in periodic increments.

The Bottom Line

While tax-advantaged 529 savings and prepaid tuition funds have their pitfalls, the alert plan owner can offset the risks with smart strategies and informed choices. There’s a tax-wise option to suit almost everyone.