They’re Not Completely Fool-Proof: 529 College Savings Plans

529 College Saving Plans have always been a great vehicle for parents and family members to start saving early in a child’s life for their college education. However, you do have to pay attention to the rules.

The new tax law now allows 529 plans to be used for paying for educational expenses from kindergarten to high school to college, says Investopedia in a recent article, “Top 7 Mistakes to Avoid on Your 529 Plan.” Keep in mind that financial professionals are still telling parents that the best use of the funds is for college. Part of that reasoning: the longer period of time that invested funds can grow.

However you use it, there are some things you want to avoid, if you want your 529 investment to pay off when your child is ready to go to school. Here are the top seven mistakes that could cause problems:

1. Failing to First Consider Your State Plan. The number one mistake is picking the wrong plan. When you do your research, begin with your state plan first to see what it offers. Every state offers at least one 529 plan, but they vary. A big benefit with your state plan is that your contributions in more than 30 states can result in a tax credit to lower your annual state tax bill. If you reside in one of five states (Pennsylvania, Arizona, Maine, Kansas or Missouri), you can invest in any state’s plan and still get the tax benefits they offer.
2. Not Understanding Your State’s Guarantee. There are states that provide prepaid tuition plans. However, not all tuition guarantees are identical. Some states offer the chance to lock in tuition fees, provided that your child chooses to go to an in-state school. It is important to use caution, because many states that make this guarantee, don’t guarantee your returns. If your returns fall short, there may not be sufficient funds, even at the guaranteed tuition rate.
3. Failing to Watch Fees and Expenses. Fees and expenses can have a big effect on the success of your investment. Research done by the Financial Research Corporation found that the average annual fee for a 529 plan is 0.69%, if purchased directly from a state. Those 529 plans purchased through brokers average 1.17%. That difference in fees adds up over time.
4. Forking Out Money for Unnecessary Penalties to Switch Plans. If you start out in a 529 plan and realize you’ve made a mistake, you can switch plans. However, use care to avoid penalties and taxes. You are allowed only one penalty-free rollover into a new 529 in any 12-month period. The one exception is if you want to change the family member who’ll benefit from the plan. It’s wise to avoid any risk of penalty or taxes, by working with the new plan administrator to coordinate the transfer. There are other fees in some states, like a recapture tax on past tax deductions, if you do an out-of-state rollover and fees to provide rollover services. Ask about all possible fees, if you are thinking of changing 529 plans.
5. Incorrectly Withdrawing Funds. When you’re ready to start using the funds for your child’s education, be sure you withdraw those funds correctly. The money can only be spent on qualified higher education expenses (QHEE), and if you don’t follow the rules, it can result in taxes and penalties. You should also remember that if you withdraw money before your child enrolls in college, you’ll pay taxes on the money—including an additional 10% penalty on any earnings (not your original deposit). Don't remove the money before your child enrolls. Then just withdraw what’s needed to cover the child's QHEE.

Consider all grants and scholarships when figuring out the amount of money you can withdraw in any one year. You are required to subtract money your child receives from other sources, before taking out 529 funds. If you take out too much, the overage will be deemed taxable income, and you’ll have to pay that additional 10% penalty on the earnings. If your child doesn’t need the money, you’re allowed to transfer the money to another family member without any tax or penalty. You can also save it in the fund for the child's future use, such as graduate school.

6. Non-Qualified Expenses. There are some common college costs that do not qualify as expenses for 529 money, like student loan pay-offs or transportation costs.
7. Waiting to Contribute. The best strategy is to open an account and start funding it shortly after your child is born. You benefit from the longest possible period of time to save, the growth of your investments over time, and the excellent habit of saving on a regular basis. Remember that even if one child doesn’t use the funds, another one can. No need to wait, whether your contributions are large or small.

Reference: Investopedia (May 29, 2018) “Top 7 Mistakes to Avoid on Your 529 Plan”