What Is the Downside of 529 Accounts?

One significant downside of 529 accounts is the account owner's complete control over the funds, which can potentially impact the beneficiary. While 529 plans offer numerous tax advantages for saving for education, they do come with certain limitations and risks that prospective investors should understand.

Owner Control and Beneficiary Vulnerability

Unlike some trusts or custodial accounts, the account owner of a 529 plan maintains full legal power over the funds. This means:

• Changing Beneficiary: The owner can change the designated beneficiary to another eligible family member at any time, without the current beneficiary's consent.
• Account Liquidation: The owner can choose to liquidate the account at any point. While non-qualified withdrawals of earnings are subject to income tax and a 10% penalty, the principal contributions can typically be withdrawn without penalty.
• Investment Direction: The owner dictates how the funds are invested, within the options provided by the plan.

This level of control can be a considerable disadvantage if the person who established the 529 plan (e.g., a grandparent or even a parent) has a change of heart about where or how the investment should be directed, potentially leaving the intended student without the anticipated funds.

Other Key Downsides of 529 Accounts

Beyond the issue of owner control, several other aspects can be considered disadvantages of 529 plans:

• Limited Investment Options:
  • Most 529 plans offer a pre-selected menu of investment portfolios, often including age-based portfolios (which automatically become more conservative as the beneficiary approaches college age), static portfolios, or individual fund options.
  • While this simplifies investing for some, it means less flexibility and fewer choices compared to traditional brokerage accounts. Investors cannot choose specific stocks or a wide array of exchange-traded funds (ETFs) or mutual funds.
• Penalties for Non-Qualified Withdrawals:
  • If the funds are not used for qualified education expenses (which include tuition, fees, room and board, books, supplies, equipment, and even K-12 tuition, apprenticeship program costs, and up to $10,000 in student loan repayments), the earnings portion of the withdrawal will be subject to federal income tax and a 10% penalty.
  • While exceptions exist (e.g., beneficiary receives a scholarship, dies, or becomes disabled), this penalty can be a significant deterrent if plans change.
• State-Specific Benefits:
  • While you can invest in any state's 529 plan, the primary state income tax deduction or credit for contributions is often only available if you invest in your home state's plan. If you choose an out-of-state plan that might have lower fees or better investment options, you could miss out on a valuable state tax break.
• Impact on Financial Aid:
  • Assets held in a 529 plan are considered parental assets (if the account owner is the parent), which typically have a lower impact on financial aid eligibility (assessed at 5.64% of assets) compared to assets held directly in a student's name (assessed at 20%).
  • However, 529 plan distributions are generally not counted as income for financial aid purposes if the parent is the owner.
  • The student's FAFSA (Free Application for Federal Student Aid) will still consider the 529 assets as part of the Expected Family Contribution (EFC), though their impact is often less significant than other types of assets.
• Fees:
  • 529 plans, like other investment vehicles, come with various fees, including management fees, administrative fees, and underlying fund expenses. These fees can erode returns over time, so it's important to compare fee structures across different plans.

Summary of Downsides

To provide a clear overview, here's a summary of the primary drawbacks:

Despite these downsides, 529 accounts remain a popular and effective tool for education savings due to their tax benefits and flexibility, provided individuals are aware of their limitations.