Pitfalls of 529 Plans
Saving money for college used to mean depositing money in an old-fashioned savings account that grew according to the sum of deposits plus interest earned. Since 1995, every state has sponsored a 529-plan that is designed to encourage parents to set aside money for college each year. The funds are invested in various securities that can offer significant growth in the fund. However, the 529-plan is not the best and certainly not a failure-safe approach to saving for college.
1. Fees and expenses – Each state 529-plan has internal expenses that are paid from the plan proceeds. One percentage point difference can cost thousands of dollars in the final sum available for college expenses. A $10,000 investment on the child’s day of birth should grow to almost $40,000 with an 8 percent return and 0.1 percent internal expenses. A plan with 1.1 percent internal expenses would grow to less than $33,000. Fees inside the plan reduce the amount of money that is available for interest compounding over the course of the plan.
2. Risk balance – As the beneficiary, or student, approaches the end of high school, the plan should be invested in conservative investments that will reduce the fund balance fluctuations. Rebalancing each child’s fund is wise since the early years should be focused on growth objectives and the later years on investment efforts. Many investors forget to adjust the risk balance each year. The changes should be made at the same time each year instead of reacting to market performance.
3. Incorrect risk – Significant market events have caused 529-plan investors to select funds that carry little risk. This approach limits the growth that would be possible in more risky funds. The investor must balance risk tolerance with the need for significant growth early in the plan’s life. Splitting the fund into multiple instruments may be the best way to diversify and reduce overall losses.
4. Retirement sacrifice – Older parents must beware of the tendency to choose a 529-plan investment over personal retirement savings. This can be catastrophic if there will not be enough working years left to save after the children graduate from college. Some parents are choosing to pursue scholarships and other instruments over saving in a 529-plan. Repaying a home mortgage can be a better long-term choice than saving money in a 529-plan.
5. Mismanaged withdrawals – Wise financial managers will pursue every means of financial assistance for college when the student is in his senior year of high school. Scholarships and grants should be sought based on the grades earned. Only after the other funds have been applied should any money be withdrawn from the 529-plan. Early withdrawals can result in increases in the household income, which increases the tax obligation. This can actually penalize the student when potential colleges review the federally-required FAFSA form for financial assistance for college.
6. No contributions in tough times – Dips in the markets and loss of household income can combine to prevent 529-plan contributions. Lower prices should indicate the perfect time to invest money. Every effort should be made to sustain contributions every year.
7. Withdrawals before college – Costly penalties are assessed if the money in the 529-plan is withdrawn before the student goes to college. Income taxes and a 10-percent withdrawal penalty must be paid in the year of the withdrawal. Some investors will withdraw funds to avoid losses. This scenario can be avoided if the funds are moved to less risky funds to reduce the risk of loss.
8. Impact on financial aid – All financial aid programs evaluate the presence of a 529-plan when considering the financial need of the student. The oldest child will incur the greatest impact since all of the 529-plan funds are visible when he enters college. Distribution between the siblings is not considered when financial need is assessed. A scholarship for academic excellence or sports performance will not be negated when a 529-plan exists for the student. Parents can transfer the 529-plan to a sibling if the scholarship covers all college expenses.
9. Alternatives to 529-plans – Some investors choose to take a different route in the quest to save for college educations. Anyone who moves often will want to consider the flexibility offered through other instruments that are not tied to one state. Financial performance can be stronger in one of these accounts since there are more funds available.
Parents have different aspirations than children do when the decision to select a college must be made. Some high school students have no desire to go to college. A 529-plan can be transferred to a sibling in this event.
After significant research, parents may decide that the 529-plan has too many limitations to be the best choice. Financial instruments of other types can offer more growth and flexibility for use of the funds in other ways outside a college education. Consideration must be given to other life events including healthcare, repaying the mortgage and saving for retirement.
Please see our article “The Best College Planning Investments” for alternatives for 529 plans.