Whether you’re saving for your own education or your children’s, you’ve probably run into 529 plans. Many tout these state-sponsored, tax-advantaged accounts as one of the best ways to stash cash for your family’s educational future. But you might be shocked to learn that these specialty plans don’t have the best track record.
What are 529s?
529s are college savings vehicles that allow investors to stash cash or buy redeemable college credits. Many offer some kind of tax savings – usually deductions or credits – in the process.
Most jurisdictions offer some form of 529 plan. However, states (and some colleges) set their own plan parameters, and there’s no guarantee you’ll reach your goals.
The secret underperformers of the investment world
A shocking 2023 study from the National Bureau of Economic Research found that 50% of 529 accounts underperform their targets. The primary culprits: “high expenses and tax inefficiency.” To make matters worse, underdogs are expected to sustain losses of 9% over their projected lifetimes.
(The study also found a ray of sunshine. As households grow more financially literate and plan documents use simpler language, investments in “sub-optimal home-state accounts” decreases. The takeaway: working with a professional – or growing your own knowledge – can save you from a bad investment.)
Hidden risks of 529 plans
529s come in two basic forms:
- Tax-advantaged investment accounts
- Purchasing college credits to be redeemed later
Investors who opt for cash savings must navigate a sea of state-specific investment options, fees, and potential tax credits or deductions. Buying college credits carries its own downsides – namely, committing to going to a specific college or colleges.
Not to mention, 529 program managers aren’t fiduciaries (required to act in your best interests). That means they can stick your money in high-cost funds that eat your savings with no consequences. And even when they do act in your best interests, most plans still severely limit your investment choices.
Sometimes, you can’t avoid taxes and penalties
529s set strict parameters for what counts as an “eligible” educational expense. If tuition and books were cheaper than expected, you might graduate college with cash leftover in your account.
…Now what?
Unfortunately, you’ll have to resign yourself to paying taxes and penalties to cash out. Typically, this includes federal (and possibly state) income taxes, plus a 10% withdrawal penalty, applied to any gains.
Of course, you could let the account grow on the chance that you or a family member will use it later. But if further education isn’t in the cards, you’ll have to take the penalty eventually.
When 529s are a bad idea
For some families, using a 529 gives a jumpstart on educational expenses. But between managers selling subpar plans and their potential to underperform, they’re definitely not risk-free.
Consider avoiding 529 plans if you:
- Live in a state that doesn’t offer incentives for 529 savings
- Are positive your children won’t attend college
- Feel comfortable navigating the investment markets on your own
- Want to expand your options beyond limited 529 assets
- Are worried about losing federal financial aid (which, if you save enough, you will)
Investing is all about making choices
Every investment has pros and cons to consider before diving in. While some families benefit from 529s, the extent of those benefits heavily relies on choosing the right plan in the right market. Tax advantages are the main reason families use 529s, and you'll have to see what works for you.