5 Costly 529 College Savings Plan Mistakes

In part because of the tax breaks they offer, 529 college savings plans have become a popular way to set money aside for one of the biggest bills most of us will ever face. The total assets in these state-sponsored accounts recently topped $234 billion, up from $90 billion a decade ago, according to the Investment Company Institute.

But popular doesn’t necessarily mean trouble-free. If you’re thinking of investing in a 529 plan for a child’s college education, it pays to know about these common missteps—and how to avoid them.

1. Focusing only on taxes. Currently, 34 states and the District of Columbia offer full or partial tax deductions or credits for 529 plan contributions. For that reason, you probably want to look at your home state’s menu of 529 offerings first. But don’t assume that a tax break automatically makes an in-state 529 the best possible deal. Not only do some states forgo any tax incentives, but a better performing 529 in another state may outweigh any possible tax savings.

“In states like mine where there is no state income tax, there is really no reason to use the local plan when other states offer lower expenses and better investment selection,” says Austin, Tex. financial planner Jeff Weeks.

The website savingforcollege.com has a handy map that breaks down how much of a tax break each state’s 529 plan offers.

2. Overpaying for advice. You can invest in a 529 in one of two ways: by working through a financial adviser or buying directly from the plan. If you’re comfortable making your own investment decisions, you’ll save on sales charges and other fees by going the latter route.

Some large brokerage firms also favor the 529 plans of particular states, “so clients may receive unfavorable tax treatment because it's not the plan for their state of residency,” says Charlie Shipman of Blue Keel Financial Planning in Weston, Conn.

3. Not knowing what “qualifies.” The money in your 529 can be withdrawn tax-free only for what the IRS considers “qualified expenses.” Generally speaking, that includes tuition and fees, room and board up to certain limits, and required books and supplies. Expenses such as insurance and transportation, however, don’t qualify.

4. Taking too little risk—or too much. You’ll sacrifice much of the growth potential of your 529 plan if you choose investments that are needlessly conservative. It’s understandable to want the money you’ve earmarked for college to be safe, but try to counterbalance safer investments, such as a bond fund, with sufficiently aggressive choices, such as stock funds, which offer the best long-term growth prospects.

Don’t go too far, though. Once college is only a few years away, you’ll want to shift the portfolio to a more conservative balance to protect against any last-minute plunge in value. Some age-based or target-date 529 portfolios will do that for you, automatically ratcheting down their risk based on your child’s age.

“But for those who build their own portfolio, it is imperative that the equity allocation is reduced as the expense approaches,” says Matt Carbray, of Ridgeline Financial in Avon, Conn.

5. Rushing to cash out. If you’re fortunate enough to have money left over in the 529 plan after your child is done with college, don’t just withdraw it. If you do, you’ll face a 10% penalty as well as income taxes on the account’s earnings. Bear in mind that you have other options, such as leaving the account intact in case your child decides to go back to grad school or changing the account beneficiary to another family member.