Just because you’ve researched the right 529 college savings plans for your children—and funded them appropriately—doesn’t mean your job is done. Not quite yet. Saving for a child’s college education is never easy. Still, 529 college savings plans offer an excellent option: These investment vehicles are expressly designed to cover higher-education expenses with the potential for tax-deferred growth and tax-free qualified distributions. In addition, many states offer tax benefits for contributions to their plan. Although you’re not restricted to your own state’s plan, you should consider the tax benefits provided by your state before investing in another’s.
But 529 plans don’t guarantee that you’ll save enough to pay for tuition by the time the first bill comes due. They still require careful management between the time when you set them up and decide your contribution rate (if you haven’t calculated the monthly figure yet, use our college savings calculator), and begin to pay tuition.
You can help protect your savings by avoiding these five common 529 mistakes.
Mistake #1: Assuming your money will grow
A 529 plan might be called a college savings account, but don’t let the word “savings” fool you. Unlike a bank savings account, it generally isn’t federally insured. It’s an investment account. Your investments aren’t guaranteed to grow, and their performance depends on your selections, as well as market conditions. People can, and do, lose money in 529 plans. You can mitigate the risks by starting a 529 plan early, so that you have more time to recover from any market losses.
Mistake #2: Forgetting to adjust your asset allocation and savings rate
When you shop for a 529 plan, you have the option of choosing an age-based strategy or a static one. An age-based portfolio holds more stocks than bonds initially, and grows more conservative over time (like a target-date fund).
The static option, where you choose the investments, sticks to the mix of assets you pick. If you go with this option, bear in mind that you’re responsible for periodic rebalancing, and for adjusting the asset allocation over time. As with many investment goals, the standard advice here is to reduce your equity stake as you near your goal.
Also, it’s not a bad idea to increase your annual contribution rate every year by, say, a base of 2% to take into account the effect of inflation.
Mistake #3: Getting the timing of your contributions wrong
Contributions to 529 plans must be made by Dec. 31 to have them count toward the current year for gift tax purposes. This differs from tax-advantaged retirement savings accounts like IRAs, for which you typically have until mid-April of the following year to contribute for income tax purposes. However, if your in-state 529 plan offers a state income tax deduction, the April deadline might apply in that case.
The Dec. 31 deadline is important to keep in mind if you want to claim state tax benefits. The same goes for the federal $14,000 gift tax exclusion, though any overages can be applied against your $5.49 million lifetime gift exemption. Keep in mind that in the year you exceed the gift tax threshold, you must also file a gift tax return. See the instructions to Form 709 for more information.
Mistake #4: Getting the timing of your withdrawals wrong
Once your child has begun college and the bills start rolling in, be careful to take out only the money you will use for qualified college expenses within that calendar year.
Also, make sure the expenses you intend to claim are on the IRS-approved list of qualified expenses for 529 plans, and aren’t already covered by other tax-advantaged sources like scholarships.
Mistake #5: Emptying an account when your child doesn’t need the money
Speaking of scholarships, what if your child ends up winning a full or partial free ride to college? In that case, you can withdraw the exact amount of the scholarship, and the usual 10% penalty on nonqualified distributions would be waived. The remainder in the account can be used for other qualified expenses that aren’t covered by the scholarship.
What if your child decides to attend a foreign institution where you can’t apply 529 funds tax-free? You’ll have to pay taxes and the 10% penalty on earnings, plus state income taxes (if you took that deduction).
You have other options before you resign yourself to taxes and penalties, however. If your child intends to pursue an advanced degree, you could leave the money in the plan where it will continue to have tax-deferred growth potential and can later be used to help pay for graduate school.
Or, if you have other children, you could make them the beneficiaries of the funds without paying any penalty or tax. Just be sure to make the switch before the next child begins college.
A third option is to designate yourself the beneficiary, and apply the funds to your own continuing education courses. You can also wait and designate the funds for your grandchildren.