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Why You Shouldn’t Use a 529 Plan to Save for College

Published by Hamilton Software, Inc. on July 20, 2014 | Comments

A key component of your college savings plan, the 529 Plan, may not really be a smart option at all, and that goes for a number of similar savings vehicles being recommended for parents with college-bound kids.

These plans are recommended so routinely that consumers and financial professionals alike have accepted them as a foregone conclusion... something everyone should automatically include in their financial plan. Ironically, such plans make sense for only a very few, and you are likely better off without participating in them at all.

This is for several reasons... the plans are restrictive, rules vary from state to state, participation can disqualify you for financial aid, and the benefits they provide can be obtained in simpler ways.

The idea behind 529 Plans and Education IRAs (aka Coverdell ESAs) is that any money you put in them will grow tax-free, and the money you withdraw to pay for qualified college expenses will be tax-free at the time you withdraw it. Sound familiar? It’s exactly the same concept as the Roth IRA, the difference being that the money is earmarked for college rather than retirement. Like the Roth, if you make a non-qualified withdraw from an Education IRA or 529 Plan you'll pay both income tax and a 10% penalty on any earnings that accumulated while the money was in the plan.

We’re told repeatedly by the financial industry these plans are an excellent way to save money by sheltering it from Uncle Sam. In fact, the opposite is true. Those families who might qualify for financial aid (and that includes most of us) will be penalized by Uncle Sam for using them. Here's how...

You'll want to apply online for federal student aid via FAFSA at the year you begin applying at colleges. The application is free and is used by both state and federal governments as well as most public and private schools to determine eligibility for what is effectively a discount on your tuition. Most middle-income families will qualify for something, unless your income is too high, or your college-available savings are too high.

What are your college-available savings? They basically include any assets that aren’t earmarked for something else. They do not include your home, your pensions, your 401k Plans, or your IRAs (both traditional and Roth). But guess what is included… All the money you so diligently saved in your Education IRAs and 529 Plans will be counted against you as schools determine how much you should be charged for your child’s attendance. In fact, if you’ve saved enough money to pay the entire tuition you'll get no break at all, while your less responsible neighbors might get a discount just because they didn't save. The discount can be substantial, amounting to thousands of dollars each year.

But what about the special tax advantages of education plans like the 529? The surprising answer is, you get the same tax advantage from a Roth IRA. A little-known fact about Roth IRAs is that the IRS allows you to make tax-and-penalty-free withdrawals at any time to pay for qualified education expenses. That means you can use your Roth IRA exactly the same way you would use an Education IRA or 529 Plan, with exactly the same benefit (a similar provision exists for traditional IRAs as well, allowing you to withdraw money early to pay for college without a 10% penalty). The only difference between using Roth money versus an education plan is that putting it in an education plan restricts its use only for education, and makes it count against you at financial aid time!

Many advisors recommend 529 Plans as a good way to “catch up” if you haven’t stashed enough in another tax-sheltered plan. 529 Plans have higher annual contribution limits than Roth IRAs, thus you can put $30,000 in a plan two years before your kids are ready to go to college, and get a tax savings on the two years of earnings they will produce. That’s fine advice for those who have $30,000 of surplus money laying around in an unsheltered savings account that they can’t find anything else to do with. But for the vast majority of us, there are much better ways of preparing for college, even if we start only two years in advance.

Contribute the maximum to your Roth IRAs. In two “catch-up” years, you and your spouse can contribute $22,000 to your IRAs. Since you’ll be pulling that money back out to pay for college in two years anyway, you won’t be locking it up any more than if you did nothing, you’ll get the same tax break you would with a 529 plan, it isn’t restricted to school costs, and it won't disqualify you for financial aid.

Convert old 401k Plans to IRAs. Any 401k Plan from a previous employer can be converted to an IRA, often with little more than a phone call. This is generally a good thing to do anyway because an IRA provides more flexibility than a 401k. Once the money is in an IRA it can be tapped to pay college expenses without penalty.

Pay down your mortgage. Your home is not included in college-available savings when you’re being considered for federal financial aid. If you have $30,000 saved in an unsheltered savings account for college expenses, and you have $20,000 in a Roth IRA, consider paying $20,000 of the college savings towards your mortgage and using the Roth money to pay for college in its place. You’ll shelter $20,000 from financial aid consideration, and in the end, you will have transferred your Roth savings to your home, which actually provides a better tax shelter than the Roth.

It is also not a good idea to put money in your child’s name because that is also counted against you when applying for financial aid.

So who can benefit from a 529 Plan? Those who’s income is so high they won’t qualify for financial aid under any circumstances or who have a large amount of unsheltered money that can’t be sheltered any other way. For those people, a 529 Plan might be the best option if they start early enough to make it worthwhile. The paradox is, the earlier you start, the less sense 529 Plans make (use a Roth IRA instead), and the later you start, the less benefit they provide. Considering the restrictions, state-to-state differences, and the financial aid penalty, you're probably better off saving for college the way you save for everything else; start early, use IRAs, and keep it simple!


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