Don’t Make These 529 College Plan Mistakes

According to stats from The College Board, between the 2002–03 academic year and the 2012–13 academic year, tuition and fees at private nonprofit four-year colleges rose by an average of 2.4% per year. Over the past decade, the inflation rate for public four-year colleges was also high at 5.2%.
Today, the average cost for just one year at a private nonprofit college—that includes tuition and fees, as well as room and board–comes in at $39,518. At a public university, it’s $17,860—and that’s paying in-state tuition!

One of the best ways to save for these mind-boggling costs is to open a 529 savings plan, which is a state-sponsored, tax-advantaged account. With any 529 savings plan, the money that you invest will grow without being subject to federal income tax. And you’ll also avoid paying federal income taxes on any money that you take out of the plan—as long as you use it to pay for qualified educational expenses, such as room and board, tuition and books.

A total of 34 states, as well as the District of Columbia, offer a state income-tax deduction or credit for residents who contribute to their state’s 529 savings plan. Five states—Arizona, Kansas, Maine, Missouri and Pennsylvania—provide a state income-tax break if you contribute to any state’s 529 plan. Check with your advisor. But before you rush to invest in one of these plans, there are some pitfalls that should be on your radar—like these top nine blunders that well-meaning parents tend to make.

1. Investing In A Prepaid 529 Without Reading The Fine Print
529 savings plans aren’t the only type of 529 out there. Some states also offer 529 prepaid tuition plans that allow you contribute money today in order to lock in prices at a state university years from now. You generally pay a premium over current tuition prices to account for inflation, but considering the rate of tuition growth in recent years, paying in advance often still sounds like a good idea..
But there’s a catch.
Despite promotional language about these plans being risk-free, mot states don’t guarantee your returns. If you live in Florida, Massachusetts, Mississippi or Washington, which do offer guarantees, then this type of plan could be a good fit. Otherwise, you have no commitment that your money will cover your child’s education if tuition growth outpaces your investments. Non guaranteed states on their prepaid plans? Illinois, Kentucky, Maryland, Michigan, Nevada, Pennsylvania, South Carolina, Virginia and West Virginia

2. Not Taking Advantage Of The Gift Tax Exclusion
529 plan contributions are considered gifts in the eyes of tax law, and the 529 gift tax exclusion is an excellent way for, say, grandparents to contribute to a grandchild’s education and avoid estate taxes. But not enough people go this route.

In general, you can give gifts to people for amounts up to $14,000 per year without paying a federal gift tax. But when it comes to 529 plans, there’s more flexibility:

You can contribute up to $70,000 at the outset, “front-loading” your plan for five years. So this means that you can contribute $70,000 in the beginning, but then you can’t contribute more for another four years.

3. Withdrawing Too Much Money
You know how much tuition comes out on paper, but are you taking out the right amount? Some parents withdraw funds from their 529 plans too hastily—before taking into account all possible grants and scholarships. That may not sound like a big deal, but if you don’t match the expenses with the withdrawals correctly, then you could face taxes on the earnings.

For example, say you’re in the 25% federal income tax bracket. If you take out $20,000 to pay for your kid’s tuition, but you only need $18,000 to cover the bill because junior received a scholarship, you would owe $500 in federal taxes on the extra $2,000, unless you used it for other qualified educational expenses.

4. Using Distributions to Cover Unqualified Expenses
Not every college cost is a qualified expense that you can pay with a distribution from a 529 savings plan. For instance, you cannot use a 529 savings plan to pay

for student loans or transportation costs. It’s also trickier to utilize funds from a 529 plan to cover room and board if you live off-campus. Typically, universities will provide an estimate for off-campus room and board that’s comparable to on-campus living. If that’s not the case with the school your kid is attending, avoid spending more on room and board from your 529 savings plan than a student living on campus would pay.

5. Setting It … And Forgetting It
It’s important for your 529 investments to reflect how long you have before you need the money back. The more time that you have, the more you can afford to opt for riskier allocations, such as stocks. If you have less time, you should invest more conservatively, with bonds or certificates of deposits. Over time, some

investments will succeed more than others, so it’s important to adjust your portfolio every year, instead of simply sticking with the same game plan during the life of your 529 savings plan. The good news is that many 529 plans offer advisors that manage the portfolios, based on your child’s age, and they rebalance the portfolio for you for a fee.

6. Pulling Out Money to Cover Other Expenses
529 plans are not emergency funds, so withdrawing early to pay for emergency life expenses will stick you with a 10% penalty, plus taxes on the earnings. And that’s not to mention that taking out the money before it’s time will greatly reduce your ability to save enough before your kid reaches college age.

8. Starting Too Late
If you don’t begin thinking about college costs until your kid is a teen, you don’t have very much time. And since you can open a 529 plan even if you don’t have a child yet (just make yourself the plan’s beneficiary and then change it when junior is born), there’s no reason not to plan ahead. It’s normal to be overwhelmed by all of your 529 choices, but don’t let doubt paralyze you. If your plan isn’t 100% perfect now, you can change it later: 529 plans allow investors to change their portfolios once a year, and you can withdraw your money from one 529 plan and invest it in another plan at any time.

It’s also tempting to put off saving because you believe that your child will score a full ride on a scholarship as an athlete or a merit scholar. You may be right, but full rides are rare—and you don’t want your kid to suffer the consequences of your misplaced optimism. If your child does get a scholarship, you can transfer a 529 savings plan to a sibling or another beneficiary—even yourself!—to be used tax-free for qualified education expenses.
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