The Disadvantages of 529 Plans

  Most people are familiar with 529 plans. These are investment vehicles used specifically to save for educational expenses like college. They’re great because families won’t pay taxes on the earnings made within their 529 investments. They are the most common way American families save for college and it’s how I’ve chosen to save for my own children. 529 plans are not perfect though and there are some disadvantages that savers should be aware of.

One of a 529’s biggest disadvantages is that funds can only be used for what the federal government calls qualified expenses. These categories include tuition, room and board, and some educational supplies. These are the most expensive costs related to attending college, but in reality, they probably don’t cover the full cost of keeping a young person who is away at college afloat and content. Further, the amount that you are able to withdraw from a 529 for each category is capped by the college or post-secondary institution the student attends. This can be a problem in some scenarios. For example, if the college you attend sets their off-campus living expense at $500 a month, that’s the most you can withdraw from your 529 plan to pay for an apartment you might rent. If you find an apartment that costs $600 a month to rent, you can still choose to live there, but that extra $100 for rent is going to have to come out of your pocket and not your 529 savings.

Another disadvantage is that the money a family has stashed away in a 529 plan is considered an asset when a college calculates financial need. This can work to reduce or eliminate a student’s financial aid eligibility for things like Federal Pell Grants, need-based scholarships, and subsidized student loans.

Both of these points conspire to create somewhat of a disincentive to save in a 529 plan or at least to over-save. To be sure, having too much money saved for college is a good problem to have, but it can be problematic nonetheless. A family who found themselves with a surplus of 529 funds they were unable to find another use for could withdraw and pocket the surplus, but they’d be forced to pay taxes on the earnings that were leftover in addition to a 10% penalty. That could be a costly sum. Those other uses I mentioned could be redirecting the 529 funds to a student’s sibling or sitting on it a little longer in case the student decided to go back to school for a master's or doctorate program down the road. 

To get around these drawbacks to 529 plans, some savvy parents have chosen some other savings vehicles that might not be truly intended for educational savings but get the job done. These might include taxable brokerage accounts, IRAs, Uniform Gift to Minor Accounts (UGMAs), or even whole life insurance policies. Families can speak to financial advisors if they are interested in these as a 529 plan alternative.