The Hidden Pitfalls of 529 College Savings Plans

The year-end push to contribute to a 529 state college savings plan is in full force. These plans make a lot of sense. But they also have drawbacks. Here's how to make the most of them.

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The year-end push to contribute to a 529 state college savings plan is in full force. Such contributions reduce your federal and often your state tax burden in the year they are made; earnings grow free of federal and most state income taxes.

Once the calendar flips you’ll have missed your shot at reducing your tax bill this year. So funding a 529 plan—or as many as you like, for that matter—makes just about every accountant’s list of savvy year-end money moves. These plans are available in every state and now command some $135 billion in total assets. That’s up 48% in five years.

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The plans are highly flexible when it comes to qualifying expenses (books, computers, room and board), and the assets can be easily transferred between beneficiaries. But 529 plans have drawbacks, as pointed out in the Los Angeles Times.

Some of the pitfalls are obvious. Yes, a 529 plan is a market-based investment and, like your 401(k) plan, will not do the job it was intended if markets suffer a long drought and you do not save enough. The Times cites a study that drives home the point:

“A family that put away $1,000 a year in a fund indexed to the Standard & Poor’s 500 beginning in 1979 would have saved enough 18 years later to pay for 4.27 years at a public college or 1.84 years at a private school, according to the study by Education Sector, a nonprofit think tank in Washington. But a family that put the same amount each year in a 529 plan beginning in 1990 and needed it in 2008 could have afforded only 0.72 of a year at a public school or 0.32 of a year at a private one.”

What a difference a bull market makes. But most people know that part of the deal going in. You have to monitor a 529 plan and adjust contributions along the way if this is your sole source of college tuition. Other drawbacks:

  • You can make only one investment change a year. Experts argue that this may prevent you from nimbly shifting to more conservative assets if markets suddenly turn south. On the other hand, it may also prevent you from panicking and selling at the bottom, which seems the greater risk. Still, year-end is the time to make a change if you think one is in order. That way you can make another move as soon as next month if you so desire.
  • You have limited investment options. A 529 plan typically has limited investment options, which center on funds with age-based asset allocations and those concentrated in broad large-cap indexes like the S&P 500. This prevents you from making an outsized bet on, say, small-cap stocks, which did much better than the broad S&P 500 the last 10 years. On the other hand, 529 investment options are designed to keep things simple and keep you from taking a flier, which is usually the best approach. Still, to broaden your options, split college savings between a 529 plan a child IRA, which can be tapped for college expenses without triggering penalties and will not hurt your chances at financial aid.

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