Don't Make These 529 Savings Plan Mistakes

You want the best education for your child, but college costs have increased tremendously over the past decade.

According to stats from The College Board, between the 2002–03 academic year and the 2012–13 academic year, tuition and fees at private nonprofit four-year colleges rose by an average of 2.4% per year. Over the past decade, the inflation rate for public four-year colleges was also high at 5.2%.

Today, the average cost for just one year at a private nonprofit college—that includes tuition and fees, as well as room and board–comes in at $39,518. At a public university, it’s $17,860—and that’s paying in-state tuition!

One of the best ways to save for these mind-boggling costs is to open a 529 savings plan, which is a state-sponsored, tax-advantaged account. With any 529 savings plan, the money that you invest will grow without being subject to federal income tax. And you’ll also avoid paying federal income taxes on any money that you take out of the plan—as long as you use it to pay for qualified educational expenses, such as room and board, tuition and books.

A total of 34 states, as well as the District of Columbia, offer a state income-tax deduction or credit for residents who contribute to their state’s 529 savings plan. Five states—Arizona, Kansas, Maine, Missouri and Pennsylvania—provide a state income-tax break if you contribute to any state’s 529 plan. (For more information, savingforcollege.com has free tools that allow you to compare various 529s.)

But before you rush to invest in one of these plans, there are some pitfalls that should be on your radar—like these top nine blunders that well-meaning parents tend to make.

1. Forgetting About the Fees Like mutual funds, most 529 savings plans charge a percentage of your investment to cover operating costs. The plans fall into two basic categories—those sold directly by the states and those sold through investment advisers, the latter of which tend to be more expensive.

According to the Financial Research Corporation, a typical 529 plan offered through a state has an average annual fee of 0.69%, whereas a 529 sold through a broker has an average annual fee of 1.17%. Although the difference may seem negligible at first, it adds up. If you invested $10,000 over 18 years (assuming you’d get a 6% return), you could have $2,000 less in a 529 plan with a 1.17% fee, compared to a plan that charges 0.69%.

2. Investing in a Prepaid 529 Without Reading the Fine Print 529 savings plans aren’t the only type of 529 out there. Some states also offer 529 prepaid tuition plans that allow you contribute money today in order to lock in prices at a state university years from now. You generally pay a premium over current tuition prices to account for inflation, but considering the rate of tuition growth in recent years, paying in advance often still sounds preferable.

But there’s a catch.

Despite promotional language about these plans being risk-free, most states don’t guarantee your returns. If you live in Florida, Massachusetts, Mississippi or Washington, which do offer guarantees, then this type of plan could be a good fit. Otherwise, you have no commitment that your money will cover your child’s education if tuition growth outpaces your investments. States that don’t offer promises on their prepaid plans? Illinois, Kentucky, Maryland, Michigan, Nevada, Pennsylvania, South Carolina, Virginia and West Virginia.

3. Not Taking Advantage of the Gift Tax Exclusion 529 plan contributions are considered gifts in the eyes of tax law, and the 529 gift tax exclusion is an excellent way for, say, grandparents to contribute to a grandchild’s education and avoid estate taxes. But not enough people go this route.

In general, you can give gifts to people for amounts up to $14,000 per year without paying a federal gift tax. But when it comes to 529 plans, there’s more flexibility: You can contribute up to $70,000 at the outset, “front-loading” your plan for five years. So this means that you can contribute $70,000 in the beginning, but then you can’t contribute more for another four years.

4. Withdrawing Too Much Money You know how much tuition comes out on paper, but are you taking out the right amount? Some parents withdraw funds from their 529 plans too hastily—before taking into account all possible grants and scholarships. That may not sound like a big deal, but if you don’t match the expenses with the withdrawals correctly, then you could face taxes on the earnings.

Let’s say that you’re in the 25% federal income tax bracket. If you take out $20,000 to pay for your kid’s tuition, but you only need $18,000 to cover the bill because junior received a scholarship, you would owe $500 in federal taxes on the extra $2,000, unless you used it for other qualified educational expenses.

5. Using Distributions to Cover Unqualified Expenses Not every college cost is a qualified expense that you can pay with a distribution from a 529 savings plan. For instance, you can’t use a 529 savings plan to pay for student loans or transportation costs. It’s also trickier to utilize funds from a 529 plan to cover room and board if you live off-campus. Typically, universities will provide an estimate for off-campus room and board that’s comparable to on-campus living. If that’s not the case with the school your kid is attending, avoid spending more on room and board from your 529 savings plan than a student living on campus would pay.

6. Setting It … and Forgetting It It’s important for your 529 investments to reflect how long you have before you need the money back. The more time that you have, the more you can afford to opt for riskier allocations, such as stocks. If you have less time, you should invest more conservatively, with bonds or certificates of deposits. Over time, some investments will succeed more than others, so it’s important to adjust your portfolio every year, instead of simply sticking with the same game plan during the life of your 529 savings plan. The good news is that many 529 plans offer pre-set portfolios, based on your child’s age, so they rebalance automatically. If you’re not invested in one of them, make sure to rebalance annually.

7. Pulling Out Money to Cover Other Expenses 529 plans are not emergency funds, so withdrawing early to pay for emergency life expenses will stick you with a 10% penalty, plus taxes on the earnings. And that’s not to mention that taking out the money before it’s time will greatly reduce your ability to save enough before your kid reaches college age.

8. Passing Up Free Rewards Don’t leave opportunities to boost your child’s 529 on the table. Credit cards, such as those offered by Upromise and Fidelity, contribute cash from qualified purchases to certain 529 plans. Upromise’s card, for example, pays up to 5% cash back, and it works with 30 different 529 plans administered by Upromise Investments in 16 states. And Fidelity’s card will turn 2% of your purchases into cash deposits through one of the four 529 plans that Fidelity manages.

9. Starting Too Late If you don’t begin thinking about college costs until your kid is a teen, you don’t have very much time. And since you can open a 529 plan even if you don’t have a child yet (just make yourself the plan’s beneficiary and then change it when junior is born), there’s no reason not to plan ahead. It’s normal to be overwhelmed by all of your 529 choices, but don’t let doubt paralyze you. If your plan isn’t 100% perfect now, you can change it later: 529 plans allow investors to change their portfolios once a year, and you can withdraw your money from one 529 plan and invest it in another plan at any time.

It’s also tempting to put off saving because you believe that your child will score a full ride on a scholarship as an athlete or a merit scholar. You may be right, but full rides are rare—and you don’t want your kid to suffer the consequences of your misplaced optimism. If your child does get a scholarship, you can transfer a 529 savings plan to a sibling or another beneficiary—even yourself!—to be used tax-free for qualified education expenses.