Advantages and Disadvantages of a 529 Plan

When planning for future education expenses, many families turn to 529 plans for their tax advantages and flexibility. However, it’s essential to weigh the advantages and disadvantages of a 529 plan to determine if it aligns with your financial goals. Understanding both the benefits and potential drawbacks can help you make an informed decision about using this popular savings tool.

And if you need help seeing where a 529 plan fits into your financial plan and budget, consider reaching out to a financial advisor.

What Is a 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to help families save for future education costs. These plans are named after Section 529 of the Internal Revenue Code and are sponsored by states, state agencies or educational institutions. The primary appeal of a 529 plan is its tax benefits: contributions grow tax-free, and withdrawals for qualified education expenses are also tax-free.

Types of 529 Plans

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

Prepaid tuition plans allow account holders to purchase credits at participating colleges and universities for future tuition and fees at current prices. These college savings plans are beneficial for families who are confident that the beneficiary will attend a participating school. With this plan, they are able to lock in tuition costs while protecting against inflation. However, they typically don’t cover other expenses, such as room and board, and may have residency requirements.
Education savings plans are more flexible and can be used for a wider range of educational expenses, including tuition, room and board, books and supplies at any accredited institution. These plans are similar to investment accounts and offer a variety of investment options, such as mutual funds or exchange-traded funds. The account’s value can fluctuate based on the performance of these investments, providing the potential for growth but also falling subject to market risk.

Benefits of a 529 Plan

Before investing in one, it’s important to understand the advantages and disadvantages of a 529 plan, so you can make the right choices for your family’s financial future. A 529 plan can offer many advantages for families looking to cover future education expenses, including these.

Tax advantages. Contributions to a 529 plan grow tax-free, and withdrawals used for qualified education expenses are also tax-free. This means you won’t pay federal taxes on the earnings as long as the funds are used for approved purposes.
High contribution limits. 529 plans generally allow for high contribution limits, often exceeding $300,000 per beneficiary, depending on the state. This enables families to save a substantial amount over time.
Flexibility in use. Funds from a 529 plan can be used for a variety of education-related expenses, including tuition, room and board, books, supplies and even certain K-12 costs. This gives families the flexibility to use the savings as needed.
No income restrictions. Unlike some other savings accounts, there are no income restrictions for contributing to a 529 plan. This makes it accessible to families of all financial backgrounds.
Potential for state tax benefits. Many states offer tax deductions or credits for contributions to their own 529 plans. These state-specific benefits can further enhance the plan’s value.
Estate planning benefits. Contributions to a 529 plan are considered completed gifts for federal tax purposes and can reduce the taxable estate of the contributor. This feature can be advantageous for estate planning purposes.
Account ownership control. The account owner retains control over the funds in the 529 plan. They can change the beneficiary to another qualifying family member if the original beneficiary doesn’t use the funds.
Investment options. 529 plans typically offer a variety of investment options, including age-based portfolios that automatically adjust the investment mix as the beneficiary approaches college age. This helps reduce risk and simplify the investment process.

Drawbacks of a 529 Plan

While 529 plans offer significant benefits for education savings, they also come with some potential drawbacks. These are some common disadvantages that families should consider before investing.

Potential overfunding. If the beneficiary receives scholarships, decides not to attend college or doesn’t incur as many educational expenses as anticipated, the remaining funds in the 529 plan may face penalties if withdrawn for non-qualified expenses.
Impact on financial aid. Funds in a 529 plan are considered parental assets, which can affect a student’s eligibility for need-based financial aid. This could reduce the amount of financial aid the student receives.
Market risk. The value of a 529 plan can fluctuate based on market performance. If the investments perform poorly, the account balance could decrease, impacting the amount available for education expenses.
Penalties for non-qualified withdrawals. If the funds are used for purposes other than qualified education expenses, the earnings portion of the withdrawal is subject to federal income tax and a 10% penalty. This limits the flexibility of the funds if the beneficiary decides not to pursue higher education.
Limited investment options. 529 plans typically offer a limited range of investment options managed by the plan’s administrator. This might not be ideal for those looking for more control over their investment choices.
State-specific restrictions. Some benefits of 529 plans, such as state tax deductions or credits, are only available to residents of the state sponsoring the plan. Additionally, some states may have residency requirements or other restrictions that limit the plan’s benefits.
Fees and expenses. 529 plans can come with various fees, including enrollment fees, maintenance fees and management fees. These costs can reduce the overall returns on the investment.

How to Open a 529 Plan

It's essential to weigh the advantages and disadvantages of a 529 plan to determine if it aligns with your financial goals.

Once you’ve decided a 529 plan is the right fit for your education savings goals, the next step is to open and fund an account. Fortunately, the process is straightforward.

1. Research and Compare State Plans

Every state offers its own 529 plan, and you’re not limited to your home state’s plan. Start by researching your own state’s offering to see if it provides tax deductions or credits for residents who contribute. If your state doesn’t offer these benefits — or if another state’s plan has lower fees or better investment options — you can open a plan elsewhere.

Websites like SavingForCollege.com make it easy to compare plans by state, fees, performance and features.

2. Gather the Necessary Information

To open an account, you’ll need to provide some basic personal and financial details, including:

Your Social Security number or taxpayer ID
The beneficiary’s Social Security number and date of birth
Your contact information, including your address, phone and email
Your bank account information to fund the account

It typically takes 15 to 20 minutes to open the account online.

3. Choose an Investment Option

Most 529 plans offer a range of investment portfolios, including age-based options that automatically adjust from more aggressive to more conservative as the beneficiary gets closer to college. Alternatively, you can choose a static portfolio with a fixed allocation of stocks, bonds and cash.

If you’re unsure which option is best, consider your risk tolerance, the beneficiary’s age and your timeline for using the funds. Many plans include tools or risk questionnaires to help you decide. You can also work with a financial advisor.

Bottom Line

A couple reviews their 529 plan savings.

A 529 plan is a popular option for education savings. While the tax benefits and high contribution limits are appealing, potential impacts on financial aid and market risk are significant considerations. By carefully evaluating the advantages and disadvantages of a 529 plan, families can decide if it aligns with their financial and educational goals.

Ask a financial advisor about how to plan for your child’s upcoming educational expenses, including whether opening a 529 plan is right for your family.

Tips for College Savings

A financial advisor can help you budget for a 529 plan as part of your overall financial plan or savings strategy. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
You’re not limited to investing in one type of plan or the one sponsored by your state. You can shop around to find a 529 plan that meets your needs, and we’ve reviewed 529 plans across the country to rate their features and benefits.