Should You Second Guess Your 529 College Savings Plan?

Consider this when determining what’s best for your child’s future.

Rhiannon Schade is a college counselor at a company that helps parents and teens navigate the college application process. She saves for her two-year-old daughter, but she has decided not to open a 529 college savings plan for the girl, who has a rare syndrome that may affect her ability or desire to pursue higher education.

“As a college counselor, I assumed that a 529 [savings plan] would be automatic for us,” Schade says. “After we learned about my daughter’s condition, I was forced to think more broadly about what it means to set aside money for your child’s future. She may choose to go to college or pursue some form of postsecondary education, but I want to understand and respect that she may also choose not to.”

Schade is one of many parents questioning whether a 529 plan is the best way to save for their children’s future. While her case is unusual in that a medical condition may affect her daughter’s future, some parents are leery of a plan that can only be used for higher education costs. Some parents worry about tying up so much money, based solely on the presumption that their child will definitely attend college. Others feel that their children would be better served by cash without restrictions, and still others imagine that by the time their child is going to college, free tuition programs will be the norm.

We asked financial experts whether 529s really are the best option for savings for kids. Here’s what they said:

What Is a 529 College Savings Plan?

A 529 is a tax-advantaged savings plan that allows people to save for future higher education costs. The downside, in most people’s eyes, is that 529 plans must be used for some sort of higher education. If the money is used for something else, full taxes and a penalty must be paid.

“If assets within the plan are not utilized for qualified educational expenses due to the child not attending college, not finishing college, or not using the entire account balance, the benefits are fully taxable with an additional 10 percent IRS penalty, and may require the contributors to pay back any tax deductions received by contributing towards the plan,” explains Tyler Boling, a financial advisor with Reed Financial in Glastonbury, Conn.

What Happens if Your Child Doesn’t Go to College?

Experts pointed out that, while the funds in 529 plans must be used for higher education, there are ways to use the funds without penalty — even if the beneficiary doesn’t go to college or trade school.

“The good news is that the beneficiary on the account can be changed,” says Kristen Moon, the owner of Moon Prep, a service based in Atlanta, Ga., that guides teens through the admissions process. “The money can be transferred to a sibling. Also, if a parent decides to return to school, they can also use the money. The one criteria is that the money must be used for a qualified educational expense.”

If parents open an account and none of their kids attend school, the funds could even eventually be put in the name of a grandchild.

Ted Jenkin, a certified financial planner, said that he allocated money to his kids’ 529s with the ability to change beneficiaries in mind.

“I funded the oldest of my three with the most amount of money,” he says. “This way, whatever she didn’t use, I could change beneficiaries to my younger ones.”

What Are the Other Options?

Although 529 plans can be transferred within families, that wouldn’t help if free tuition programs become the norm within the next decade or two, as some people predict. Because of this, some parents are most comfortable avoiding 529 accounts.

Instead, they might consider a Roth IRA. Since colleges do not factor in retirement accounts when analyzing parents’ assets, this has the added benefit of potentially making your child eligible for additional financial aid.

“A Roth IRA is a great alternative to a 529 plan as the contributions to a Roth are after tax and accessible at any time without taxation,” Boling says. “This allows parents to cover multiple bases. If the child goes to college, they can withdraw their Roth contributions to help pay for college without any of it being counted towards the estimated family contribution. If the child doesn’t go to college, the parents have the assets within a retirement account and accessible without the constraints or possible penalties of the 529 plan unused assets.”

It’s important to note that, even though there’s no added penalty if you use Roth IRA funds to pay for qualified education expenses, you will still owe income taxes on the portion of the distribution that would otherwise have been subjected to income tax.

Another option is a custodial account, known as a UGMA account (because it was established under the Uniform Gift to Minors Act). These accounts allow minors to own assets, but Richard Barnes, a tax professor at the University of North Carolina at Pembroke, says they are outdated due to the emergence of more sophisticated and appealing investment options.

“UGMA accounts have lost virtually all their former attractiveness,” he notes.

What’s the Bottom Line?

Whether to open a 529 account or save for your child in another way is ultimately a decision for you, your partner, and your financial advisor. However, Barnes points out that, whether or not they are ultimately used for higher education, 529 plans provide a great benefit: delaying taxes.

“CPAs and attorneys often talk about ‘a tax deferred is a tax destroyed,’” he says. “Money you have now, or save now, is more valuable than money you will acquire in the future. In business, this idea is referred to as the ‘time value of money.’ The point behind it is that when you put money into a 529 plan and invest it, at a minimum, you defer income tax on gains until they are withdrawn. Under the tax rules, you defeat income tax completely if the 529 proceeds are used for higher education or related expenses. If you do not use the final proceeds for higher education expenses, you pay income tax, at future rates, on the profits from the 529.”

That, he says, is one huge advantage of 529 plans that is often overlooked.

“When planning, consumers tend to focus on the immediate tax benefit of a tax-related move — we put money into a traditional 401(k) because we don’t have to pay tax on it today — but that is only part of the tax benefit and is often dwarfed by delayed tax on the earnings.”

Join the Discussion

4 Responses to “Should You Second Guess Your 529 College Savings Plan?”

  1. Lisa Hastings

    Another benefit to 529 plans is that some states provide state income tax deductions for contributions.

    Also, even though the 529 constrains the use of the funds, this isn’t always a bad thing. People know if they are liable to “spend their savings”; if they are, they may want to use a 529 (esp if they have multiple children) so that they (the spending parents) don’t spend all the college money on other things.

    Also, 529 can be used for more college expenses than just tuition!

    I think people should start saving and investing for their child’s future when they are born, in some vehicle or multiple vehicles. There is nothing to stop a parent from saving one way, and once they were pretty sure their child would go to college or pursue some higher education, open a 529.

    The Roth idea is good, but unless the parents have significant retirement assets, it’s too much mixing of the two needs for me.

    However, parents should also remember that tell their teenagers as soon as they earn any income to open a Roth IRA. A Roth in a teenagers name has the same positives, but it keeps it separate from the parents’ actual retirement funds. It’s not much, but it helps.

    • Cindy Brooks

      I was going to comment on two things. One of them was the tax benefit in some states. We live in one of them and enjoy that deduction from our state taxes! Thanks for mentioning that. The other is that 529 funds are no longer counted as an asset on the student’s FAFSA (Free Application for Federal Student Aid). It use to be and hurt a lot of parents and students who diligently saved for their higher education. A lot of students had to spend down their 529 funds before they could qualify for financial aid. Last spring I attended a financial aid seminar at our school as we have an exchange student who will be a senior this coming year and we wanted to find out what might be available for him. The speaker announced that 529 funds are no longer included as financial resources on the FAFSA! Hurray for that! We’re feeling good about the money we’ve saved for our grandson who is starting his freshman year in high school. With this new rule he’ll have a much better chance of receiving some grants. This sentence in the post, “Since colleges do not factor in retirement accounts when analyzing parents’ assets, this has the added benefit of potentially making your child eligible for additional financial aid” made it sound as though it is still considered a student resource.

  2. Libby

    It’s important to note that funds placed in a UTMA or UGMA account are owned by the child/potential student. Assets owned by the child/potential student have a much more damaging effect (4-5 times the impact) on qualifying for financial aid than assets still owned by the parent. Further, because of the restrictions of the UTMA/UGMA account, they cannot be returned to the ‘giver’ (parent or grandparent) to reverse this effect. If the student has any possibility of qualifying for need-based financial aid, a UTMA/UGMA is a bad idea.

  3. Dr. Rosché

    529 plans also have to be reported on FAFSA as assets which may not allow for other government assistance.
    Life Insurance has multiple functions and could be used as an alternative way to save money tax free, that doesn’t need to be reported on FAFSA and doesn’t have restrictions of using for higher education only. Contact me for a FREE Financial Checkup