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This Is Why You Might Want To Skip A 529 Plan

There’s a certain level of anxiety that can test your fortitude when it comes to financing college education. You might find yourself grappling with as many questions as there are college course options:  How soon should you start saving for your child’s education? How much should you set aside? Should you plan on taking out a school loan? Is a scholarship even a possibility?

At some point, you might consider a 529 plan as a means of setting aside money for college. A 529 plan is  state-sponsored, tax-advantaged education investment account that, on the face of it, seems like a smart choice, but it does have some drawbacks. Here’s a primer on what this type of plan offers, which could help you decide if it’s a good fit for your college financing needs.

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Types Of 529 Plans

There are two main types of 529 plans: prepaid tuition plans and savings plans.

With a prepaid tuition plan, you can pay in advance for tuition at certain colleges and universities, but at today’s prices. Money invested in this type of plan will grow over time, and any accumulated capital gains will be tax free. Keep in mind, however, that prepaid plans only cover tuition and exclude other educational expenses such as room and board.

Savings plans allow money set aside for education to grow tax deferred; in addition, any withdrawals your makes will be tax free if they’re applied to qualified educational expenses. You might want to consider this type of plan if you’re unsure of which college or university your child will attend.

Savvy Move Or Savings Misstep?

Investing in a 529 sounds like a smart move, but in some instances it could cost you – and your child – money.

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On average, 529 plans come with higher fees than other investment options such as mutual funds. The investment company Vanguard found that the industry average for 529 fees is 0.40%, which is double the amount paid on average for a passive mutual fund. Although the fee may not seem like a lot in and of itself, multiple fees can quickly add up if you contribute the maximum amount to your 529 fund each year; in the end, the total amount of fees could reduce the returns on your investment.

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With a 529 plan you’ll need to select a specific investment option; 529 options can vary widely depending on the provider and the state where you live. Generally, the investment options for this type of plan are limited as compared to those offered with other types of investment options such as Roth IRAs.

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Distributions from a 529 plan that’s owned by a third-party, such as a grandparent, family friend, or some other benefactor, are counted as untaxed income. This additional income could negatively impact your child’s qualification for financial aid, subsidized loans, work-study programs, and grants. On the plus side of the ledger:  It’s possible to time the distribution from a 529 so that it doesn’t need to be included in your child’s Federal Student Aid (FASA) application.

Photo: Flickr/Laura Billings

You invested. You saved. Now you’re counting on your 529 to pay for your child’s education. But what happens if they decide college isn’t for them? Or if they follow a career path right after high school? Or they choose a local, less expensive school instead of the private college for which you’ve been saving, year after year? As the saying goes: The best laid plans…

Bear in mind that if you end up with too much money in your 529, you’ll pay a 10% penalty on any interest accrued during the life of the plan. And a penalty in that amount could reduce your 529 plan earnings by a significant degree.