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By Ingrid Case
June 28, 2021
A college kid with various patches on his backpack (representing the 529 savings plan) leaping over a cliff edge.
Kiersten Essenpreis for Money

Saving for college in a 529 plan is easy — in theory, at least. To start, you have only to choose a plan and begin putting money away.

But despite the apparent simplicity, it is possible to mess up a college savings plan, even after you’ve succeeded with the much more difficult task of setting aside money to save in the first place.

Forty-nine states and the District of Columbia offer 529 plans, which allow consumers to invest after-tax money and then spend the earnings tax-free on educational expenses. As long as you spend money from a 529 plan on those qualified educational expenses, you’ll get the tax savings that are the main point of this investment vehicle.

Yet experts say errors that prevent you from enjoying a 529 plan’s full suite of benefits are surprisingly common and easy to make. Here’s what to watch out for.

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#1: Leaving a state tax deduction on the table

Twenty-nine states give you either a deduction or a tax credit for at least some of your 529 plan contributions, as long as you’ve invested in your own state’s plan. Another seven states are happy to give you a tax benefit for investing in any 529 plan, no matter where it is located.

If you live in one of the states that only gives you a tax break if you invest in your own state’s plan, you should seriously consider choosing that plan, says Mark Kantrowitz, the Chicago-based former publisher of savingforcollege.com. and author of How to Appeal for More College Financial Aid.

“That’s free money,” he says.

Christopher Lyman, a financial planner at Allied Financial Advisors in Conshohocken, Pennsylvania, adds that he often sees clients who don’t realize that they’re leaving money on the table.

“Not knowing that your state has a tax deduction or credit is surprisingly common,” Lyman says. “I have clients who live in Georgia but have kept their Pennsylvania plans, not realizing that they could have deductions in a high-tax state.”

Just one caveat: Once you get a state tax deduction or credit for a 529 plan contribution, the state may expect you to repay that money if you ever transfer those funds to another state’s plan.

#2: Not choosing carefully between low fees and a state tax deduction

You don’t want to unintentionally leave a state tax break on the table. But there are times when it makes sense to choose to forgo the tax deduction in favor of saving in another 529 plan that carries lower fees. Which is better depends on the student’s age, Kantrowitz says.

“With a young child, fees matter more,” he says, because fees affect your investment’s long-term compounding. “When the kid enters high school, the state income tax break matters more,” he says, because at that point, the investment has just four years to compound.

#3: Stopping 529 contributions when your kid enters college

Most states give you a tax break when you put money into a 529 plan, no matter how long the money stays there. You could contribute the money in August, then take it out to pay tuition bills in September.

The situation is more complicated four others states — Montana, Wisconsin, Minnesota and Michigan — though it is still possible to get a tax break for contributing money while your kid is in college.

Those four states “base the tax break on contributions net of deductions, which means you could still make contributions in even years and take money out in odd years,” Kantrowitz says.

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#4: Missing the American Opportunity Tax Credit

If you have enough 529 plan money to pay for all four years of college, smile with relief and don’t worry about tax credits.

But if you will need to draw from multiple sources of money, spread the 529 plan out over four years, so that you can grab the American Opportunity Tax Credit for every year it’s available to you. (You’ll need to earn less than $90,000 for single people or $180,000 for a couple.) Worth up to $2,500 a year, the American Opportunity Tax Credit is the best of the federal educational tax breaks, Kantrowitz says, benefitting most people even more than the tax savings a 529 plan generates.

The credit is equal to 100% of the first $2,000 spent on qualified expenses, and 25% of all expenses beyond that, up to a maximum credit of $2,500 per student, per year. To get the entire $2,500, you’ll have to spend $4,000 on tuition, books, supplies or equipment for post-secondary education.

But the IRS won’t let you double-dip by using untaxed money to generate a tax credit. If you want the full credit, that $4,000 will have to come from a bank account, loan or taxable brokerage account. It can’t come from a 529 plan, a grant or a scholarship.

For example, imagine that you’re spending $25,000 a year on qualified college expenses. Of that total, you can pay $21,000 from your child’s 529 plan or by finding a grant or scholarship to cover the bill. The remaining $4,000 has to come from after-tax money.

#5: Choosing a 529 plan through your financial advisor

Many states offer both a 529 plan you can open on your own and a plan you must open through a financial advisor. In most instances, Kantrowitz says, the two plan types have different investment options, with the direct-purchase plan expecting you to make more of your own investment choices. An advisor-guided plan’s returns might benefit from extra investment advice, but probably not enough to make up for what are usually much higher administrative fees in the plan itself. A direct-purchase 529 plan is typically the better choice.

More from Money:

How to Pay for College

Almost No One Saves for College. Can New 529 Apps Help?

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