Avoid These 529 Plan Mistakes When Saving for Your Kids

by Miranda Marquit · 3 comments

With all things having to do with your financial future, it makes sense to start saving as early as possible. This is true of college as well.

If you plan to send your child to college, now is the time to start saving up. College tuition keeps rising, and by the time your child is ready to attend school, there’s a good chance your child will be drowning in debt if he or she is solely relying on student loans to make ends meet. You’ll have to help your child pay for college some other way.

One of the best things you can do is start saving now, and to consider using a 529 account for the purpose.

The Power of Compound Interest

A 529 college savings plan is a popular choice for many parents looking to help their children save up for college. This is because you can put the power of compound interest to work on your behalf. A 529 plan allows you to invest money, and as the assets appreciate in value, the amount you have for college increases as well.

Compound interest works best when you have a longer time frame, though. If you have the money in the account for between 15 and 20 years, you are likely to see better performance overall than if you frantically try to save up for three to five years. Plus, over time, the markets tend to even out, and lose the volatility you often see with short-term investing. The longer you have your money in an investment account (as long as you choose the right type of funds), the better you are likely to do over the long haul. Starting a 529 plan when your child is just a baby can be a great way to put the power of compound interest to work on your behalf.

Reap the Tax Benefits

It’s also possible that you might be able to reap the tax benefits associated with investing in a 529 plan. Some states (but not all) offer a tax deduction on the state income tax return. There’s no federal benefit, but if you live in certain states, you might see a tax advantage anyway.

Also, the money in the 529 account grows tax-free. That means that when your child withdraws the money for qualified education purposes, he or she won’t have to pay taxes on the money. (If the money is used for something other than a qualified purpose, taxes apply.)

Mistakes to Avoid with a 529 Plan

It’s important to be careful about how you proceed when planning the 529, though. Ownership of the account matters when it comes to taxation on the earnings, as well as when it comes to how much financial aid your child qualifies for.

There are many other pitfalls you want to avoid with a 529 plan. JJ Montanaro from USAA offers some insights on mistakes that you should avoid with a 529:

Do You Have a Plan for Your 529?

According to Montanaro, you can’t just open a 529 and have it turn into a success. You need to have a savings plan in place. Figure out how much you need to put in the plan to succeed, according to your goals. Since we plan to pay for living expenses and books, we have a different goal amount than if we were trying to pay for tuition as well. Decide what your goals are, and base your savings plan on what you expect.

Who’s the Account Owner?

It’s important to make a distinction between the owner of the account and the beneficiary of the account. This is a big deal when determining financial aid. You could reduce your child’s ability to qualify if they own the account (and the assets). Montanaro points out that this can also be an issue for grandparents who want to help out. “Grandparents are well-intentioned when opening a 529 for their grandchild, but this approach could have a negative impact on the amount of financial aid your child qualifies for,” he says. “Parents and grandparents should understand all the implications of how a 529 is set up.”

Is It a Backup Emergency Fund?

It can be tempting to raid a 529 when you run into some financial difficulty. However, your child’s 529 shouldn’t be used as an emergency fund. Montanaro says that there are tax penalties that come with withdrawing the money for non-qualified education expenses. As a result, you could end up in bigger trouble. Plus, now you’ve reduced the amount of money available for your child to use at college, and you can’t replace the missed opportunity of the interest that the capital isn’t earning.

Should You Quit When Your Child Starts College?

Finally, Montanaro warns against quitting when your child starts college. You can still make contributions to your child’s 529 throughout college. “Parents can earn tax-free money that can be used for future education expenses like textbooks and tuition,” he says. Plus, if your plan and state allow it, you might even be able to receive a tax deduction for continued contributions (there is no federal tax deduction for 529 contributions). For those who uses up everything they saved in a 529 plan before their children graduates, the benefits beats the pants off even the highest yielding savings accounts.

Make it a point to learn the ropes of the 529 plan. You might be surprised to discover how effective it can be at allowing you to build up a college fund that can benefit your child (and maybe even you) down the road.

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  • Elizabeth says:

    I’ve been looking for something like this as we aim to start a 529 for our child. Can you expand on the ownership of the account? So it sounds like it’s better to keep the account in the parent name and put the child down as beneficiary? Or do you leave the child off completely to not impact their ability to get financial aid, etc?

    • David @ MoneyNing.com says:

      There are other obvious implications but for illustration purposes, 529s are best owned (in terms of getting maximum aid) by a non-relative, followed by a grandparent, then parent, and finally in a student’s name.

      On the FAFSA form that pretty much all colleges use to determine financial aid, parent’s 529 assets can reduce financial aid by a maximum of 5.64% of the account value.

      Don’t just blindly set everything up through a grandparent though, because the timing of withdrawals from a grandparent-owned 529 can impact future financial aid as well.

      Check out this article:

      It explains everything I said in much more detail.

  • DNN says:

    I don’t have kids.

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