4 Downsides of 529 College Savings Plans

As your students embark on their college paths after high school many of their parents will be stressing how to pay for that education. 529 College Savings plans are one savings option they should be considering for those students and any younger siblings they may have.

There are some downsides though that they should be made aware of. Bankrate has published 4 downsides of 529 College Savings Plans that they should be aware of:

  1. They may not like the choices in the 529 plan:

With a 529 plan, you put in after-tax dollars, your contributions are invested, and the money can be withdrawn tax-free when it’s used for tuition or other college-related expenses.

States generally sponsor their own plans, and more than 30 offer some kind of deduction on state taxes for 529 plan contributions.

But note that you are limited to the investment options that your plan makes available. So, you could be stuck with a poor selection of investments and high administrative fees and other costs.

2. The investing window might be tight:

Many plans offer an all-in-one fund that’s similar to a target-date fund. It’s designed to own more stocks when your child is young, and more bonds and cash equivalents, like money market mutual funds, when he or she nears college.

If you get a late start, you could find yourself stuck in a tight investing time frame. Since many of your students will be juniors or seniors any family that hasn’t started investing in the earlier years won’t have much time to watch those investment dollars grow. However, it is never too late to start saving.

3. You might too easily trigger a penalty:

Some would-be savers may be turned off by the requirement that 529 funds must be used for education. Take money out for any other purpose and you could incur a 10 percent penalty as well as an income tax bill.

That’s an unappealing risk for middle-class parents who are struggling to put enough emergency savings aside for an unexpected $500 expense and have woefully underfunded their own retirement.

Families who are somewhat more comfortable would do just as well saving in a normal, taxable investment account than in a 529 plan. That’s because households in the 15 percent income tax bracket don’t pay long-term capital gains taxes.

In other words, parents earning nearly $105,000 wouldn’t owe Uncle Sam a dime when selling part of their portfolio to pay for tuition for their children.

4. A Roth IRA might be a better option:

Another alternative to consider is a Roth IRA. You’d contribute money after-tax and invest it through mutual funds, as with a 529.

But you’d be able to choose a brokerage, rather than settle for a state plan administrator.

You could withdraw your contributions without penalty, and older parents wouldn’t pay taxes at all after turning age 59 1/2.

Another positive: You could start saving much earlier. You have to wait to open a 529 plan until your kid has a Social Security number. But you could open and start to fund a Roth IRA in the year or two before you and your spouse start to think about children.

Higher earners wouldn’t qualify for a Roth IRA and would get more benefit from 529 tax savings.

Publisher’s note: One other often overlooked problem with 529 plans is that if your kid decides to go to school out of state the 529 plan dollars might not be available. Usually the principal is returned without penalty but any interest earned is lost if not used for an education in that particular state. It is important to check the rules in your specific state before investing.

What should you do?

So which is it: 529? Roth IRA?

The answer might just be: Yes.

Just as you diversify your assets, you also should diversify how you save for college, to give yourself some cover.

Use a 529 plan to guarantee some tax-free withdrawals, just in case your earnings might increase and push you into a higher tax bracket. But also fund a Roth IRA to hedge against your kid needing less money for college, and to be able to take more risk with your portfolio.

By spreading your savings around, you’ll give yourself the most financial flexibility for that day when your kid becomes a university freshman.

Here is a link to the original article on Bankrate.com