529 plans offer a useful and tax-efficient way to save for your kids' education. Still, they aren't for everyone. Limited options can offset some of the potential tax benefits. Plus options for using them beyond college costs are currently limited. As such, 529s might be considered the icing on the cake after your own retirement is taken care of. Even then you should be aware of the pros and cons of 529s before jumping in.
Start Early
The main benefit of a 529 is that the money grows and can be withdrawn free from tax. Of course, with these sort of tax shields, they are generally more useful the longer you can save for. This means that opening a 529 when your child is born (or even before they are born) makes potentially more sense than when they are, say, 16 years-old. By starting saving for a teenager and saving over just a few years until college arrives, you run a couple of risks. Firstly you may be unlucky and the markets could decline over a relatively short period. That's easy to forget after such a long bull run, but U.S. markets could be considered pricey today. Bear markets do happen. Secondly, even if they do rise then, unless those returns are spectacular, then chances are the tax savings probably won't be worth all that much.
Related: The Best And Worst 529 Plans
If you're reading this with teenage kids, then this advice, short of time travel, may not help. However, the real point is that they are other tax-efficient ways to save out there. IRAs, 401(k)s and even 403(b)s and 457(b) plans can be better bet. So it probably makes more sense to consider one of those options, than to go through the complexity of the 529 process for a relatively mild tax-benefit. Remember, you can still help your kids out with college if you want to, whether you have a 529 or not. Furthermore, once college arrives, you'll be able to assess accurately if you're securely in a position to help or not.
Make Sure Your Own Savings Are In Order First
Just as in airline safety videos, it makes sense to put on your own oxygen mask first before helping others. So it makes sense to have your own basic retirement needs met and any debt under control before saving for your kids' education. Worst case, they can always borrow to fund education costs. It's much trickier for you to borrow to fund retirement. As a rule of thumb, if you're not a decade or two from retirement and saving 15% of your income, then double check your own retirement plans are ok before looking to 529s, which are more the icing on the cake of personal financial planning.
Limited Options
Unfortunately, 529 options within many plans sometimes aren't that broad or flexible. If you like to pick stocks or build your own portfolio then the 529 options at many providers could disappoint. This is something to consider. The limited set of 529 options from many providers may mean that your investment portfolio is a bit less efficient than you would like. Maybe you're paying slightly higher fees than some of the lower cost ETFs out there, that aren't included the plan. Perhaps you have a particular bias in your investing style that can't be implemented through vanilla 529 fund choices.
Either way it's possible that constraints in how you can invest your 529 plan means that your investment returns are a bit lower than they otherwise would be, perhaps due to fees, perhaps due to limited investment options. Yes, of course, there is a tax benefit to be factor in should things work out, but if your investment performance suffers there's an obvious trade-off. There's less tax to pay if your investment returns are worse and if you lose money, maybe there's no tax benefit at all, but limitations may still apply.
Don't Save Excessively
Unlike other forms of tax-efficient saving the uses for 529 plans are relatively locked down. You can use up to $10,000 a year for elementary or secondary school and you can typically use 529 to fund certain education-related computer costs for your child. Plus the SECURE Act with its changes to IRAs and 401(k)s may also expand the use of 529s if Ted Cruz gets his way to include potentially home schooling and various special needs costs. Today though, the bulk of 529 costs are typically spent on university education. That can be a problem, because if you child doesn't go to college or even goes with a cheaper option, such as an in-state choice, then you could be hit with a 10% penalty and additional tax on a 529 balance that you may struggle to use for educational purposes.
If you have multiple kids or are feeling generous with nieces, nephews or grandchildren, that can work, because moving the balance between eligible beneficiaries is often an option. Though here you should be aware of estate planning concerns. For example, giving over $14,000 a year to any beneficiary may create tax issues. Therefore, trying to cover absolutely all of college costs with a 529 can be risky. If costs run less than expected and you don't have another child to transfer the 529 balance to, you may endure various penalties.
529 offer tax efficiency, but they are inflexible both in many investment choices and how they can be used. Plus you likely want to make sure your own retirement is in order first. 529s can be helpful, but make sure you're aware of the pros and cons going in. Whereas 401(k)s and IRAs can be broadly useful, 529s despite their tax benefits can also carry some limitations.
Related: The Best And Worst 529 Plans
