Three Common Pitfalls of 529 Plans
- Like an IRA, a 529 plan is a tax-advantaged investment account—there's no guarantee your money will grow, and you could actually lose money.
- Gift-tax rules apply when funding a 529 plan, so be sure to time your contributions appropriately.
- You can transfer the 529 plan to another family member if your child or grandchild doesn't go to college.
Utilizing a 529 plan to save for a child’s education expense can make a lot of sense. After all, if you’re going to save anyway, you might as well take advantage of every tax break available. While a 529 plan may not give you an up-front federal income tax deduction, your contributions grow tax-free and you won't be taxed on withdrawals as long as they're used for qualified expenses.
In spite of their well-known benefits, 529 plans aren't without potential drawbacks. Here are three potential pitfalls to watch out for:
1. Ignoring the risks. A 529 plan account may have special tax advantages, but just because it’s a special account for college savings doesn’t mean your investments are guaranteed to grow. Like any other account, performance will depend on investment selection and market conditions. People can, and do, lose money in 529 plans. That said, there is more than one kind of risk. By being overly conservative you could fail to meet your long-term goals, especially in a low interest rate environment. If you have more than three to five years to go before you need to start writing tuition checks, consider some stock market exposure. Remember that the sooner you start saving and investing the better your chances of capturing some growth. Just don’t take on more risk than you can tolerate, especially as your time horizon shortens.
2. Getting the timing wrong. Investment time horizon isn’t the only area where you need to pay attention to the calendar. When you make contributions and take money out of your 529 savings account can also make a difference.
- Contributions. Parents and grandparents should be careful to take the annual gift-tax rules into account, especially if you’ve previously taken advantage of the five-year gift election.1 Also, if you’re eligible for a state income tax deduction for your contribution you should coordinate it with your other year-end tax planning.
- Withdrawals. Make sure your expenses qualify before withdrawing any money. Check to see if they’re on the IRS-approved list of qualified expenses for Qualified Tuition Programs (QTP) and aren’t already covered by other tax-advantaged sources like scholarships. Also, be careful to only withdraw money you will use for college expenses within the same calendar year or penalties could apply.
3. Failing to update beneficiaries when your spending expectations change. Your child or grandchild may receive a full scholarship or decide not to go to college for a number of reasons. As owner of the account, you can switch beneficiaries to another qualified family member without incurring any penalties, income tax or gift tax. You can even make yourself the beneficiary. Check out IRS Publication 970 and consult with a professional tax advisor if you have questions.
I hope this enhanced your understanding of 529 college savings plans. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.
1. See page 6 of Form 709 – “Line B. Qualified Tuition Programs (529 Plans or Programs)".
Call 888-903-3863 to learn more about Schwab's college savings options.
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Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. This information and more about the plan can be found in the disclosure statement or Participation Agreement available from your financial institution and should be read carefully before investing.
As with any investment, it’s possible to lose money by investing in a 529 or other college savings plan. Additionally, by investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan.
Information provided is for general purposes only and is not intended to be a substitute for specific individualized tax or legal advice. Where specific advice is necessary or appropriate, please consult a qualified tax or legal advisor.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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