Opening a college savings account is a smart way to invest in the education of a family member, a friend, or even yourself—and it often comes with tax benefits.
A popular option is a 529 college savings plan. This investment vehicle was primarily designed to cover higher-education expenses with tax-deferred growth and the potential for tax-free qualified distributions. Almost all states and the District of Columbia offer some type of 529 plan. Although you’re not restricted to your own state’s plan, you should always consider the tax benefits provided by your state before investing in another’s.
A 529 plan doesn’t guarantee that you’ll save enough to pay for tuition by the time the first bill comes due. It still requires careful management, such as determining your contribution rate and how to invest your contributions, between the time you set it up and when you begin to pay tuition. (This is also the case for pre-paid tuition 529 plans. While they offer certain guarantees to keep up with the cost of tuition, you still have to save enough to cover other expenses.)
You can help improve the benefits you receive from investing in a 529 plan by avoiding these five common 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. Like a 401(k), your money isn’t guaranteed to grow, and your plan’s performance depends on your investment selection, as well as market conditions.
It’s important to note that your investments can fluctuate, and you can lose money in a 529 plan. Your purchasing power can also decrease due to inflation, which means your investments may not keep up with the cost of college.
You can help mitigate these risks by starting a 529 plan early so that you have more time to potentially recover from market losses, choosing a diversified portfolio of investments based on your risk tolerance and time horizon, and taking advantage of potential compounding growth over time.
Mistake #2: Forgetting to adjust your asset allocation and savings rate
When you shop for a 529 plan, you typically have the option of choosing an age-based or a static portfolio allocation. An age-based portfolio initially holds more stocks than bonds when the child is younger and then becomes more conservative the closer the child gets to college age (similar to a target-date fund).
A static portfolio allocation 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 allocation to stocks as college enrollment approaches.
Setting up automatic 529 contributions is a great way to get things rolling without having to think about it, but it can also make you complacent about your savings goal. It’s not a bad idea to increase your annual contribution as your earnings grow, particularly if you’re starting off with a modest amount. Many parents supplement regular deposits with periodic contributions from birthday or other holiday gifts from friends and family.1
Mistake #3: Missing your contribution deadline
For most states, contributions to 529 plans must be made by December 31 to have them count toward the current year for gift tax purposes.
This differs from tax-advantaged retirement savings accounts like IRAs, where you typically have until mid-April of the following year to contribute for income tax purposes. However, if your 529 plan offers a state income-tax deduction, the April deadline might apply.
Mistake #4: Withdrawing funds too late or for unqualified expenses
Once your child has begun college, and the bills start rolling in, make sure to take out only the money you’ll use for qualified college expenses within that calendar year. This is particularly important for tuition bills that arrive in December and aren’t payable until January. In other words, withdraw the funds and pay the full tuition bill before the end of the year–don’t wait until January. Otherwise, this distribution may be seen as unqualified.
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 or scholarships.
Mistake #5: Emptying an account when your child doesn’t need the money
Speaking of scholarships, what if your child ends up with 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 of earnings would be waived. Ordinary income taxes will still apply, however. The remaining funds can be used for qualified expenses not covered by the scholarship.
If some of your child’s college expenses don’t qualify, you don’t have to resign yourself to paying taxes and penalties. For example, 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 until you pay for graduate school.
Another option is to change the beneficiary. You could name your other children as beneficiaries of the funds without paying any penalty or tax. Just be sure to make the switch before the next child begins college. You can also wait and designate the funds for your grandchildren.
A 529 plan isn’t just for children. You can appoint yourself the beneficiary and apply the funds to your own continuing education courses. Also, siblings, parents, grandparents, or other eligible family members can be named a beneficiary as long as the funds are used for educational purposes.
Creating a savings strategy
In addition to the tips above, you can avoid costly missteps with thoughtful planning. Do your research to find the appropriate college savings plan for your family. Then, work with a financial planner or tax advisor to find ways to make tax-smart savings and investing decisions.
1You can typically contribute up to $15,000 a year (or $30,000 for couples) without incurring the gift tax. It’s also possible to contribute a lump sum of up to $75,000 to one or more 529 college savings plans in a single year ($150,000 for couples) without being subject to the gift tax. The IRS views the money as an annual $15,000 (or $30,000 for couples) gift over five years. However, if you contribute more money on behalf of the same child during those five years, you may trigger the gift tax. States can also put a cap on how much can accumulate in a 529 account. Most states set the limit in the $300,000–$400,000 per beneficiary range, though some states have higher limits.