Section 529 college savings plans are among the best ways of saving for college. The earnings on contributions are tax-deferred and distributions are tax-free if used to pay for qualified higher education expenses. If the account is owned by a parent or a dependent student, the 529 plan has minimal impact on need-based federal student aid.

There are, however, a few pitfalls to using a 529 plan to save for college:

PROBLEM: Limited Investment Control

The account owner may change the investment's asset allocation no more than once a year. The IRS, however, is allowing account owners to change the asset allocation twice in 2009.

PROBLEM: Limited Choice of Investments

Most 529 plans offer a handful of broad-based stock and bond funds and various combinations of such funds. As such, the performance will tend to follow the performance of the stock and bond markets as a whole. This is usually not much of a problem, except in 2008 when the S&P 500 experienced a 38% drop. However, broad-based market indices are a good choice for long-term investments and it is a given that the stock market will drop significantly at least once during any ten year period. So one should plan for this problem. Every 529 plan includes an age-based asset allocation fund that starts off with aggressive investments when the child is a baby, and gradually shifts the asset allocation to a more conservative mix as college approaches. When the child is young, the savings are smaller and so less money is at risk from stock market losses. The child also has many years ahead to recover from market downturns. When the child is about to enroll in college, the 529 plan is invested mostly in conservative investments and so the funds are exposed to much less risk of losses.

PROBLEM: Excessive Fees

Some 529 college savings plans have high fees that may even outweigh the tax savings. This is especially true of adviser-sold plans. The solution is to focus on direct-sold plans, which have lower plans. Also, plans managed by Vanguard and TIAA-CREF tend to have the lowest fees.

PROBLEM: Limited to Higher Education Expenses

529 college savings plans may be used only for qualified higher education expenses. They cannot be used for elementary and secondary school expenses. They also cannot be used to pay down student loan debt.

If a family wishes to save for elementary and secondary school expenses, they should use a Coverdell Education Savings Account.

PROBLEM: Impact on Student Aid Eligibility

529 college savings plans owned by a parent or a dependent student have a minimal impact on need-based student aid eligibility. Nevertheless, each $10,000 in a 529 college savings plan can reduce aid eligibility by as much as $564. The solution is to fully distribute the 529 plan the first year, so that it does not stick around to affect aid elgibility in subsequent years.

PROBLEM: Coordination with the Hope Scholarship

You cannot double dip, using qualified higher education expenses to justify both the tax-free treatment of a 529 college savings plan distribution and to qualify for the Hope Scholarship tax credit. The solution is to take distributions that are smaller than the full amount of tuition and fees, leaving at least $2,000 and as much as $4,000 in expenses available for the Hope scholarship.