Named after a tax law provision, 529s made their debut in 1996 and have been used by millions of parents to save for ever-rising college costs. Contributions to the funds are not federally tax-deductible, but the investment grows tax-deferred and the IRS does not tax withdrawals – so long as the money is used on qualified college-related expenses.
There are two types of plans. Savings 529s work like a 401(k) or IRA, with money placed in a mutual fund or similar investment, while prepaid 529s let you pay all or part of college tuition in advance, providing a hedge against inflation.
Plans vary from state to state, but you can invest in a plan in any state and cash it in at any eligible institution. Risk is a factor, however, no matter where you live. For instance, if you haven’t invested in an age-based fund that grows more conservative as your child nears his or her college years and the market happens to take a dive, your savings can suddenly evaporate.
Michelle Perry Higgins, financial planner and principal at California Financial Advisors, points out other hazards: “There can be penalties for improperly using money that’s been put aside in a 529 plan. For example, if you were to take a withdrawal but it is not used for qualified higher education expenses, then the earnings may be subject to federal income tax plus a 10% penalty.
“Lastly,” Higgins said, “a 529 account may reduce your student’s ability to receive financial aid. A 529 plan is considered a parental asset on the federal financial aid application. Parental assets are used in determining the expected family contribution.”
But the advantages may outweigh the risks. You’re putting money away for college – always a good idea. And if a child opts against a higher education, you can change the beneficiary to another qualifying family member.
For families with several college-bound children, this flexibility is advantageous, and, Higgins noted, “if a parent later decides to go back to school, these are great funds to use.”
Parents should seek professional financial advice before investing. Further information about 529 plans can be obtained through a variety of websites, including www.savingforcollege.com.