How does a 529 plan work?

There are two main types of 529 plans: Savings plans and prepaid tuition plans.

Savings plans allow the money you set aside to grow tax-deferred, and any withdrawals your child makes will be tax-free as long as they’re used to pay for a qualified educational expense.

Prepaid tuition plans let you pay in advance for your child’s tuition at certain colleges and universities, but at today’s prices.

Similar to a savings plan, the money you invest in a prepaid tuition plan will grow over time and any capital gains it accumulates will be tax-free. But prepaid tuition plans do not cover room and board or other educational expenses besides tuition.

The savings plan model is usually a better bet if you’re not sure which post-secondary institution your child will attend — especially if you’re starting the account while they’re still young.

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Why a 529 plan might not be a smart move

So a 529 plan seems like an obvious win, right? Not necessarily. In some cases, investing in a 529 could actually wind up costing you — and costing your child, too. Here’s why.

The money must be used to pay for college

This may seem like a non-issue, since the whole point of opening an education investment account is to save up for your child’s college education.

But what if they decide not to go to college, and instead pursue a career straight out of high school? Or what if they choose to go to a local school that costs a lot less than the private college you’ve been budgeting for?

In both cases, you’ll wind up with too much money in your 529, and you’ll need to pay a 10% penalty on any interest you’ve earned since you started contributing to the plan.

Although you won’t get dinged with the 10% fee on the money you originally contributed, the penalty on your interest will take a significant bite out of your earnings.

You may have to cough up some hefty fees

In general, 529 plans come with higher fees than several other investment options, like mutual funds.

According to the investment company Vanguard, the industry average for 529 fees — also called expense ratios — is 0.40%. That’s roughly double the amount you’d pay for a passive mutual fund, which averages around 0.20%.

Essentially, you’ll be paying an extra two dollars in fees for every $1,000 you deposit into a 529 instead of a mutual fund.

That might not seem like a lot, but if you’re planning to contribute the maximum amount to your child’s 529 each year, it can quickly add up — and it may undercut the returns you’ll see on your investment.

Investment options are limited

When you start a 529, you’ll need to select from the investment options offered by your specific plan.

These options can vary widely by state and by provider, and they may not always be diverse enough to meet your long-term investment goals.

Other types of investment accounts, like Roth IRAs, generally offer a much broader range of investment options to choose from.

If you’re planning to open a 529 plan, it’s important to do your research before you lock one in — you may be able to find a plan with better options outside your home state.

It could hurt your child’s chances of getting financial aid

If someone else is thinking about opening a 529 plan for your child — a grandparent or family friend, for example — you may want to encourage them to pursue a different route.

Any distributions from a 529 plan that’s owned by a third-party are counted as untaxed income, and they may hurt your child’s chances of qualifying for financial aid, including grants, work-study programs, and subsidized loans.

It is possible to time the distribution from a 529 so that it doesn’t count on your child’s Free Application for Federal Student Aid (FAFSA), but you should make sure the person opening the account fully understands the steps required to do so before you give them the green light.

Alternatives to a 529 plan

If you want to save for your children’s college education but aren’t sure a 529 plan is the right call, here are some alternatives:

Savings accounts

A high-yield savings account or a certificate of deposit is a solid option for your child’s college nest egg.

Although it may not earn as much return on your investment as a 529, you’ll be able to use the money in your savings account to support your child however you want.

For example, if they decide to forgo college and start their own business, you can still help them out — and you won’t get slapped with the same 10% penalty you would with a 529 plan.

Roth IRAs

Another option is to keep your child’s college fund in a retirement account, like a Roth IRA.

While the main purpose of a Roth IRA is to save up for your own golden years, withdrawing funds early to pay for your child’s college expenses will not incur the standard 10% penalty on your capital gains.

If you’re planning to go this route, it’s a good idea to consult with a financial advisor first to make sure you understand all the rules and contribution limits that apply to Roth IRAs.

Custodial accounts

If you’re not sure whether your child will pursue a post-secondary education, a better alternative to a 529 plan might be a custodial account, like a UGMA (Uniform Gift to Minors Act) or a UTMA (Uniform Transfer to Minors Act).

Both options provide standard tax breaks for individuals under the age of 18, and there are no limits on how the money can be used as long as it benefits the child. You’ll control the funds in your child’s account until they come of age (18 for UGMAs, 21 for UTMAs), at which point they’ll get access.

These days there are even automated custodial accounts that will invest a bit of spare change for your child’s future whenever you make a purchase

Just keep in mind that if your child does decide to go to college, having a lump sum of money in a custodial account may disqualify them from receiving financial aid, similar to a 529.

Brokerage accounts

A brokerage account can be an excellent alternative to a 529 plan, especially if you’re an experienced investor.

With a brokerage account you can purchase any form of investment you’d like, including stocks, bonds, cryptocurrency, and futures.

While there are no tax advantages to saving for your child’s education using a brokerage account, if you build your portfolio wisely you could see significantly higher returns than you would with a 529.

Many brokerage accounts come with hefty fees, although these days brokerage apps like Robinhood will allow you to invest as much as you want with no trading fees or commissions.

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About the Author

Shane Murphy

Shane Murphy

Reporter

Shane is a reporter for MoneyWise. He holds a bachelor’s degree in English Language & Literature from Western University and is a graduate of the Algonquin College Scriptwriting program.

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