Saving for College with a 529: 5 Costly Mistakes to Avoid

Opening a college savings account is a smart way to invest in the education of a family member, a friend, or even yourself—and it often comes with tax benefits.

A popular option is a 529 college savings plan. This investment vehicle was primarily designed to cover higher-education expenses with tax-deferred growth and the potential for tax-free qualified distributions. Almost all states and the District of Columbia offer some type of 529 plan. (Currently, Wyoming is the only state that doesn't offer one.) Although you're not restricted to your own state's plan, you should always consider the tax benefits provided by your state before investing in another's.

A 529 plan doesn't guarantee that you'll save enough to pay for tuition by the time the first bill comes due. It still requires careful management, such as determining your contribution rate and how to invest your contributions, between the time you set it up and when you begin to pay tuition. (This is also the case for pre-paid tuition 529 plans. While pre-paid plans offer certain guarantees to keep up with the cost of tuition, you still have to save enough to cover other expenses.)

You can help improve the benefits you receive from investing in a 529 plan by avoiding these five common mistakes.

A 529 plan might be called a college savings account, but don't let the word "savings" fool you. Like a 401(k), your money isn't guaranteed to grow, and your plan's performance depends on your investment selection as well as market conditions. It's important to note that your investments can fluctuate, and you can lose money in a 529 plan. Your purchasing power can also decrease due to inflation, which means your investments may not keep up with the cost of college.

You can help mitigate these risks by starting a 529 plan early so that you have more time to potentially recover from market losses, by choosing a diversified portfolio of investments based on your risk tolerance and time horizon, and by taking advantage of potential compounding growth over time.

When you shop for a 529 plan, you typically have the option of choosing an age-based or a static portfolio allocation. An age-based portfolio initially holds more stocks than bonds when the child is younger and then becomes more conservative the closer the child gets to college age (similar to a target-date fund).

A static portfolio allocation sticks to the mix of assets you pick. If you go with this option, you're responsible for adjusting the asset allocation over time. As with many investment goals, a general suggestion is to reduce your allocation to stocks as college enrollment approaches. 

Setting up automatic 529 contributions is a great way to get things rolling without having to think about it, but it can also make you complacent about your savings goal. Consider increasing your annual contribution as your earnings grow, particularly if you start off with a modest amount. You can also supplement regular deposits with periodic contributions from birthday or other holiday gifts from friends and family.

For most states, contributions to 529 plans must be made by December 31. However, if you live in Georgia, Iowa, Indiana, Kansas, Mississippi, Oklahoma, South Carolina, or Wisconsin, you may have until the April tax filing deadline of the following year to contribute and potentially receive a state income tax deduction for income tax purposes.

Once your child has begun college and the bills start rolling in, make sure to take out only the money you'll use for qualified college expenses within that calendar year. This is particularly important for a spring tuition bill that arrives in December but isn't due until the end of January. If you pay the bill in December out of pocket, you'll need to also withdraw the funds from the 529 to reimburse yourself in December—otherwise, the distribution may be seen as unqualified. Alternatively, you may wait until January to make the payment out-of-pocket, but to do that, you must also delay withdrawing the funds from the 529 until January. You can also avoid this situation by paying directly from your 529 if allowed.

Also, make sure to claim only qualified expenses for 529 plans that aren't already covered by other tax-advantaged sources or scholarships.

What if your child doesn't need the money when college rolls around? Non-qualified withdrawals will be subject to taxes and penalties, so you should consider your options carefully.

For instance, what if your child ends up with a full or partial free ride to college? In that case, you can withdraw up to the full amount of the scholarship from that child's 529 plan. Some or all of the earnings distributed from the 529 will be taxed as ordinary income, but the usual 10% penalty on nonqualified distributions of earnings will be waived. You can use the remaining funds for qualified expenses not covered by the scholarship. 

And if some of your child's college expenses don't qualify, you don't have to resign yourself to paying taxes and penalties. If your child intends to pursue an advanced degree, you could leave the money in the plan where it will continue to have tax-deferred growth potential until you pay for graduate school.

Another option is to change the beneficiary. You could name your other children or even grandchildren as beneficiaries of the funds without paying any penalty or tax. Just be sure to make the switch before the child begins college. In fact, as long as the funds are used for educational purposes, you can appoint yourself, siblings, parents, grandparents, or other eligible family members as beneficiary as well.

Finally, you can roll unused 529 assets—up to a lifetime limit of $35,000—into a Roth IRA for the plan's beneficiary, without incurring the usual 10% penalty for nonqualified withdrawals or generating any taxable income. To be eligible for this, the account must have been open for at least 15 years, and rollovers are subject to annual contribution limits for Roth IRAs. Also, the beneficiary must have earned income up to the amount converted into a Roth IRA. That said, several details about this process still need to be clarified by the IRS. For example, does the 15-year period reset if you change the beneficiary? But for those worried about having excess funds stuck in a 529, this may be a welcome option.

In addition to the tips above, you can avoid costly missteps with thoughtful planning. Do your research to find the appropriate college savings plan for your family. Then, work with a financial planner or tax advisor to find ways to make tax-smart savings and investing decisions.