One of the biggest hurdles to early retirement for parents is helping cover the cost of their children’s college. The prevailing wisdom in many circles is to set aside funds in a 529 account. For those not familiar with 529s, a 529 plan account is a tax-advantaged savings account designed to save money towards future education expenses.
There are two main advantages to 529 savings plans. The first is that any funds that are used to cover qualified education expenses are exempt from federal income taxes. This can be a significant reduction in tax liability depending on the amount that has been saved in the account. The second advantage is that many states provide tax deductions or credits for residents. This can reduce the state tax liability of the account holder during any year when funds are contributed to the account.
Often times this is where the discussion on 529 accounts stops. However, there are several less talked about drawbacks of 529 accounts. First, if money is not used for qualified education expenses, then a 10% penalty will be applied. This pertains to any withdrawals from the account. While most parents feel that all of their children will have college expenses, there are several situations where this may not be true. Exceptional children may receive enough scholarships to cover all of their college costs. Kids may all decide to enter the skilled trades or enter directly into the military. In these cases all of the savings in the account can be reallocated to another child, grandchild or other family member but this depends on each family situation.
My main concern is since most folks recommend contributing to a 529 account from the time a child is born, there are 18 years of unknowns which could change my children’s college needs. If my children don’t need the money and I have to pay the penalty on any withdrawals, it will more than offset any tax deductions I would have received on the contributions.
The other negative for 529s is that they count as a parent asset. This is determined when calculating the financial aid for a student during the FAFSA process. A parent asset is more favorable than a student asset, but this is not the best outcome. If instead these funds were contributed to the parents 401k, these funds would not be counted as an asset at all. This decreases the amount of money that the government would expect the family to pay towards higher education costs.
Based on all of these factors I am shifting my savings away from the 529 accounts of my children. Instead I will focus on contributing the maximum amount to my 401k. I feel that this gives me the best combination of flexibility for the funds and protection from current and future tax liability. If I need to convert funds to generate a Roth IRA ladder down the road to cover college costs then I can do that. Until then I can keep my options open.