There are a lot of positive tax features of a 529 college savings plan that make it very desirable. Unfortunately, most people don’t know or understand the pitfalls of a 529 plan. Remember that when the government is in control of your money, they add taxes and penalties to those who save money in order to give it to those who don’t. Assuming your family saved all the money needed for college in a Section 529 plan (Section 529 of the IRS code means the IRS controls it) The following is a list of pitfalls to be aware of.
Financial Aid Impact #1 – Reduction in Financial Aid & Grants
A 529 plan for your child could affect their access to federal student aid. The child’s family’s full financial picture is considered when you and your student complete the Free Application for Federal Student Aid (FAFSA). Your 529 savings could increase your student’s Expected Family Contribution (EFC), which is calculated using the FAFSA. The EFC is the Department of Education’s way of estimating how much you can afford when paying for college. The higher your EFC, the fewer federal grants, work-study opportunities, and subsidized loans your child could receive.
Summary: Since you saved money under the government’s plan, your child doesn’t qualify for the benefits that are available to those who used an alternative, non-government controlled strategy. *See alternative below
Financial Aid Impact #2
A 529 plan owned by a grandparent or anyone other than the student or parent is ignored on the FAFSA (but may be considered on the CSS Profile). However, distributions from a 529 plan owned by a third-party are counted as untaxed income to the student and can reduce the student’s eligibility for financial aid.
Penalties for Non-qualified Withdrawals
If you make a withdrawal to cover an ineligible expense, it’ll be considered income. The IRS will tax you on it and add a 10% penalty.
Penalties for Withdrawals in the Wrong Year.
You might know you have a tuition bill coming down the pike and withdraw the amount from your savings plan without a second thought.
But think twice. If a qualified education expense isn’t paid in the year it occurred it may be disallowed, creating tax and penalties.
Also, be aware that if you withdraw more than $14,000 in a year to pay for tuition, that could subject you to the IRS gift tax.
Planning to move out of state?
If a 529 plan account owner does a rollover into another state’s 529 plan, any state income tax deductions and credits previously claimed may be subject to recapture, and the earnings portion of the outbound rollover may be added back to state taxable income.
What’s the Alternative?
A financial institution strategy that allows you to accumulate money at rates that are competitive with a thriving stock market, without stock market risk and without income restrictions. The strategy allows you to take the money out without penalties, or you can take collateralized loans. You get the advantages of a 529 without the afore mentioned 529 pitfalls and eliminate capitol gains tax on growth. The best part is that the money can be used for anything and on anyone (no qualified expenses).