12 Common 529 Savings Plan Mistakes to Avoid

By Kevin / August 3, 2016
12 Common 529 Savings Plan Mistakes to Avoid

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Trying to save up money for your child's college tuition? If so, you are probably using a 529 plan to help. In that case, this article is for you. Read on to find out the 12 common mistakes people make their 529 Savings Plan, and how to avoid them.

What is a 529 Savings Plam

A 529 plan is a savings plan designed to help you save for future college expenses. Also known as a qualified tuition plan, 529 plans are sponsored by educational institutions, state, and state agencies to help families set aside money for college.

A 529 savings plan is one of the most popular ways to cover schooling costs once your child reaches college age, but many Americans are not familiar with how to open and fund a 529 plan -- let alone get the greatest tax benefits.

Reasons to Save for College with a 529 Plan

Not sure if you should be using a 529 to save for future college expenses? This type of savings plan offers several benefits:

  • State tax credits or deductions for contributions
  • Tax-free withdrawals for college expenses
  • Earnings grow free of federal taxes
  • Control of the money in your account
  • No annual or income contribution limits

12 Common 529 Savings Plan Mistakes to Avoid

Before you set up a 529 plan for your child, make sure you're aware of these twelve common mistakes that can cost you big bucks.

Mistake #1: Not looking into 529 Options in Every State

You do not need to open a 529 plan in the state in which you live. It's a good idea to start by checking your own state's 529 plan as many offer special incentives for residents. Compare it against options in other states that may offer lower fees or expenses.

Right now, 34 states and the District of Columbia offer partial or full tax deductions or credits for 529 contributions. Tax incentives from your state may or may not offer the best deal, though, if another state has a better performing 529 plan. If you live in a state with no state income tax like Nevada, there really is no reason to use a plan from your state if another state offers a better selection of investments or lower costs.

Remember that your plan beneficiary can use the funds toward college costs in any state regardless of where you buy the plan.​

You can use SavingForCollege.com to compare state 529 plans and see the top-rated 529 plans.​

Mistake #2: Ignoring Account Fees

Plan fees can eat up your investment over time if you aren't careful. The average fees for directly sold 529 savings plan are 0.54%. These fees jump up to an average of 1.47%, if you choose a broker-sold plan.

These fees include maintenance fees, expenses of your underlying investments, administration fees, and sales charges if you have a broker-sold plan.

Mistake #3: Paying Too Much for Financial Advice

You have two main options for investing money in a 529 plan: buying directly from the plan or working with a financial adviser. If you feel comfortable making investment decisions, skip the high fees and sales charges of a broker-sold plan.

Mistake #4: Not Taking Advantage of the Gift Tax Exclusion

The IRS considers 529 contributions as gifts, which means the gift tax exclusion offers an opportunity for grandparents and other family members to contribute to a child's education without estate taxes. Taxpayers can generally gift up to $14,000 per year to any one person without a gift tax.

529 plans offer greater flexibility, though. In fact, you have the ability to front-load, or contribute up to $70,000 outright for five years.

Mistake 5: Taking Too Much or Too Little Risk

You want your investment to grow as much as possible, but too much risk in your portfolio can cost you. On the flip side, a portfolio that is too conservative means you will sacrifice much of your plan's growth potential.

If college is many years away, try balancing your portfolio with safer investments like bond funds with stock funds, which generally provide the best long-term return. When college begins to approach, take a more conservative approach to your investments to protect against last-minute plunges in value. An age-based or target-date 529 savings plan can automatically reduce your risk based on your child's age.

Mistake #6: Assuming 529 Savings Drastically Impact Financial Aid

A 529 savings plan is considered if your child wants to get financial aid, but not as much as you may think.

If your child is still a dependent, the 529 savings are considered parental assets by the government, which usually count as 3-5% of the total amount counted as available to pay tuition, or the expected family contribution (EFC). If your student is not a dependent and owns the 529 account, that number increases to 20%.

Mistake #7: Not Knowing What is Considered a Qualified Expense

When it's time to use the money in your 529 plan, remember that only withdrawals for qualified expenses are tax-free. The IRS generally considers tuition and fees, room and board (up to a limit), books, and supplies as 529-qualified educational expenses.

Transportation and insurance are never considered qualified expenses. If you take out money for a non-qualified expense, you will be hit with a 10% penalty and taxes on the earnings. You may also undermine the growth potential of your plan and your years of savings efforts.

Mistake #8: Paying All College Expenses with 529 Savings

Did you know there are tax credits for paying tuition? If you pay all of your child's college costs with 529 savings, you will miss out on these tax credits.

One of the best examples is the American Opportunity Tax Credit. The American Opportunity Credit offers a $2,500 tax credit for qualified taxpayers with $4,000 or more in qualified expenses.

You are not allowed to double dip on tax breaks, so you can't get this tax credit for expenses paid with 529 funds. To make the most of your savings and reduce your tax burden, try to qualify for tax credits first before touching the 529 savings.

Mistake #9: Taking Out Too Much in Any Given Year

Pay attention to how much is withdrawn from the 529 plan in any calendar year while your child attends school. Colleges charge expenses over an academic year, not a calendar year. But you your taxes are reported on a calendar year basis.

Sometimes people take out a full academic year's worth of expenses from the 529 plan without realizing that half of the expenses occur in the next tax year. If you do this, all of the excess distribution is taxable. Only take out what you need to match the academic expenses for the calendar year.

Mistake #10: Cashing Out Without Considering Your Options

Once your child is done with college, do not rush to cash out the plan if there's anything left. If you do, the IRS will hit you with a 10% penalty plus income taxes on the earnings.

You can always leave the account as-is in case your child returns to school. Or you can change the beneficiary to another family member without facing penalties. You can even make yourself the beneficiary and apply the funds to your own educational expenses if you plan to return to school.

Mistake #11: Sacrificing Retirement Savings for College Savings

It can be challenging to manage several financial goals. If you have to choose, remember this: it is always more important to choose retirement savings over education savings.

After all, your child can always get a student loan to pay for college. However, there is no such thing as a retirement loan.

Putting your retirement goals first also means you will not need to depend on your children after you retire, or be stuck delaying your retirement.

Mistake #12: Delaying Opening a 529 Account

While it's never too late to set up a 529 plan, sooner is better.

You can even open a 529 plan for a child that isn't born yet by opening the account in your name and updating the beneficiary later.

Closing Thoughts

While 529 savings plans can seem complicated at first -- and it may seem like there are many ways to go wrong -- this type of plan is one of the best ways to save for college with the ability to earn tax breaks for contributions while growing your savings tax-free.​

For the 2015-2016 school year, the average cost of tuition and fees was more than $32,000 at a private college and almost $24,000 for out-of-state residents at a public university. To put in prospective how expensive this is, using 2015 dollars, a private college education only cost $1,832 in 1971-1972.

The sooner you open an account and begin making contributions, the more time your investment will have to grow.

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