Why Are 529 Plans Considered a Bad Idea?

While 529 plans provide tax advantages for education savings, they have drawbacks. These state-sponsored investment accounts have a rigid structure and potential for financial penalties that can make them a challenging choice for some families. The limitations can introduce unexpected costs, so understanding the potential downsides is important before investing.

Penalties for Non-Qualified Withdrawals

A primary concern with 529 plans is the financial penalty for using funds on non-approved expenses. When money is withdrawn for a non-qualified reason, the earnings portion of the withdrawal is subject to two financial hits. The earnings are treated as ordinary income and taxed at the account owner’s federal income tax rate, and the IRS imposes an additional 10% federal tax penalty on those earnings.

For example, if a 529 account holds $50,000, with $15,000 being investment earnings, a non-qualified withdrawal of the full amount would have consequences. The $15,000 in earnings would be subject to both income tax and the 10% penalty. If the account owner is in the 22% federal tax bracket, they would owe $3,300 in income tax plus a $1,500 penalty, totaling $4,800 in federal taxes. This does not include potential state taxes or the recapture of previously claimed tax deductions.

Non-qualified withdrawals can be triggered by various life events, such as a student receiving a full scholarship or choosing not to pursue higher education. In these cases, the owner must either leave the funds for another beneficiary or withdraw them and incur penalties. The penalty can be waived in specific circumstances, like the death or disability of the beneficiary. It can also be waived if the student receives a scholarship, but only up to the scholarship’s value.

Impact on Financial Aid Eligibility

A 529 plan can reduce a student’s eligibility for need-based financial aid, with the impact depending on the account owner. If owned by a dependent student or their parent, the plan is reported as a parental asset on the Free Application for Federal Student Aid (FAFSA). Parental assets are assessed at a maximum rate of 5.64% when calculating the Student Aid Index (SAI). This means for every $10,000 in a parent-owned 529 plan, a student’s financial aid could be reduced by up to $564.

The situation is different for a 529 plan owned by a grandparent. Following the FAFSA Simplification Act, distributions from a grandparent-owned 529 plan are not reported on the FAFSA. This means they do not impact the student’s eligibility for federal aid, making it easier for grandparents to contribute to college costs without affecting a student’s need-based aid.

Investment and Fee Limitations

The plans also have constraints on investment management and associated costs. Most state-sponsored 529 plans provide a limited menu of investment choices, usually a small selection of age-based portfolios and a few mutual funds. This is much more restrictive than a standard brokerage account, which offers thousands of stocks, bonds, and exchange-traded funds (ETFs).

This lack of choice is compounded by rules limiting an owner’s ability to change their investment allocation. Federal regulations permit investors to change the investment options for existing contributions only twice per calendar year. This restriction can prevent an account owner from reacting to changing market conditions, a level of control that is standard in other investment accounts.

The fee structures within 529 plans can also erode investment returns. These plans can have multiple layers of fees, including annual account maintenance fees, program management fees, and the expense ratios of the mutual funds. The combined fees can be higher than the costs of low-cost index funds or ETFs available in the open market, making some state plans an expensive way to save.

Restrictions on Fund Usage

The tax benefits of a 529 plan are contingent on using the funds for Qualified Higher Education Expenses (QHEE). The definition is narrower than many families assume. Qualified expenses include tuition and mandatory fees, books, supplies, and equipment required for enrollment. Room and board costs are also covered, but only for students enrolled at least half-time.

The limitations become apparent when considering costs that are not qualified. For instance, transportation costs to and from campus, health insurance premiums, and fees for extracurricular activities are not QHEEs. Using 529 funds for these purposes results in a non-qualified withdrawal.

Recent legislation has expanded the use of 529 funds. Account holders can use a lifetime maximum of $10,000 to repay a beneficiary’s student loans and up to $10,000 per year for K-12 tuition. For leftover funds, owners can make tax-free and penalty-free rollovers from a 529 plan to a Roth IRA for the beneficiary. This option has a lifetime maximum of $35,000, and the 529 account must have been open for at least 15 years.