Published Sunday, February 10, 2013 at: 7:00 AM EST
A Section 529 college savings plan can be a tax-smart way to help your children pay for their higher education. But you should also be aware of several potential pitfalls of this planning device. Here’s a brief rundown on the main pros and cons.
The account can make money. A Section 529 plan works much like a mutual fund, with account assets typically invested in equities by professional money managers. They do the hard work while you sit back and watch the account grow.
Count on the tax benefits. Contributions to the plan are gift-tax-free, the earnings within the plan are income-tax-free and any distributions that are used for qualified education expenses are also income-tax-free. That’s a hard combination to beat.
Funds may be invested automatically. Frequently, a plan will let you have funds automatically withdrawn from your checking or savings account. Not only is this convenient, it also takes some of the guesswork out of saving for college.
Contribution limits are generous. State law effectively controls the amount you can sock away in a Section 529 plan, but the limits are favorable. In some states, you can contribute as much as $200,000 to your child’s account, which should be sufficient to cover tuition for four years at most schools.
Account assets are portable. Although 529 plans are sponsored by individual states, the money can be used to pay for college wherever your child attends. Also, if funds are left over when your son or daughter completes school, you can use the excess to pay college expenses for another child. You don’t have to close the account until the youngest child reaches age 30.
Funds must be used to pay qualified expenses. If you make a withdrawal and use the cash for any other reason—say, to pay emergency medical expenses—the distribution attributable to earnings is taxed on both federal and state levels, and you’ll owe a 10% penalty. You’ll also be taxed on any leftover amount you receive after closing the account.
The investments are out of your hands. This is the flip side of having professional money management. If you’re a savvy investor, you may prefer to have greater control over the funds. Should you be inclined to use a different investment option outside of a 529 you’ve established, you’ll be taxed and penalized if you withdraw funds and invest them elsewhere.
It might affect financial aid eligibility. The impact of a Section 529 plan is usually negligible if held by a parent. Nevertheless, it must be factored into the equation to determine the “expected family contribution” (EFC) for college costs.
For most families, Section 529 plans are a good deal, but they’re not for everyone. We can provide the necessary guidance.
This article was written by a professional financial journalist for McCarthy Asset Management, Inc and is not intended as legal or investment advice.