Updated on 03.16.15

Six Biggest Myths About 529 Plans

These tax-advantaged college savings plans fuel some common misconceptions.

Ohio State Library

Using a 529 plan to save for college doesn’t limit you to just state colleges or schools within your state. And you don’t even have to use your home state’s plan. Photo: Ohio State via Facebook

By Kathryn Flynn

A college degree is worth more today than ever before. In fact, according to a study by Pew Research, young adults with a four-year degree earn around $17,500 more per year on average than those with only a high school diploma. So the question for most families is not “will our children go to college?” but rather “how are we going to pay for it?”

One option that has been growing in popularity is a tax-advantaged 529 plan. A 529 plan works a lot like a Roth IRA – you make contributions with after-tax dollars and earnings in the account grow tax-free. You will also avoid being taxed at withdrawal as long as the money is spent toward qualified education expenses.

So why aren’t more families using 529 plans? Here are six of the biggest misconceptions that may be preventing families from enrolling:

Myth No. 1: I Have to Use the 529 Plan Offered by My State

You can generally invest in almost any state’s 529 plan regardless of where you live. However, if you pay income tax, experts recommend that you explore your home state’s plan to see if they offer any tax benefits for residents.

Thirty-three states and the District of Columbia currently offer a full or partial state tax deduction or credit on contributions to a 529 plan. If you live in one of the six states that offer tax parity, you may be eligible for a tax benefits no matter which plan you use.

But even if your state does offer a tax benefit it’s still a smart idea to check out other options. Better investment performance and lower management fees can sometimes outweigh the benefits of a tax deduction.

Myth No. 2: 529 Plans Can Only Be Used at In-State Public Universities

Funds saved in a 529 account can generally be used to pay for any college or university that is eligible to participate in U.S. Department of Education financial aid programs. This includes traditional four-year public and private universities, community colleges, graduate schools, technical schools and even some study abroad programs.

So you can live in California, open a 529 plan administered in New York, and send your child to a private college in Indiana and still enjoy all of the federal tax benefits.

Myth No. 3: It’s a ‘Use-It-or-Lose-It’ Type of Account

If your child decides not to go to college and you end up withdrawing 529 funds to make non-qualified purchases, you will incur income tax and a 10% penalty on the earnings portion of your account — your investment gains. The principal portion, which is the amount you originally contributed, will never be taxed or penalized since it is made up of after-tax money.

There are also exceptions to the penalty rule if the student dies, becomes disabled, decides to attend a U.S. Military Academy, or gets a scholarship. In these events, there will be no penalty, but the earnings portion of the account will be subject to income taxes. 

If you want to avoid paying any taxes, you can change the beneficiary of the plan to another family member who is planning to attend college. You can also make yourself the beneficiary and either use the money to further your own education or save the funds for your grandchildren. 529 funds can be passed down through multiple generations offering the chance to create an educational legacy for your family.

Myth No. 4: Once My Child Reaches Legal Age, He Can Take the Money and Run

With a 529 plan, the account owner, not the beneficiary, retains control throughout the life of the account. The beneficiary has no legal rights to the fund, even when he or she becomes an adult. This differs from custodial accounts under UGMA/UTMA, where the assets are considered the property of the minor.

Myth No. 5: I Should Not Open a 529 Plan if I’m Going to Apply for Financial Aid

You will have to report any 529 savings on the Free Application for Federal Student Aid (FAFSA), but the effect on your eligibility will usually be minimal.

When determining your Expected Family Contribution (EFC), it is assumed that only a maximum of 5.64% of a parent’s assets will be used to pay for college expenses. This is much lower than accounts that are considered the student’s assets, which are assessed at 20%.

A lower EFC means more financial aid. What’s more, because 529 withdrawals are excluded from federal income tax, they do not have to be added back to your base-year income on the following year’s FAFSA.

Keep in mind, however, that this treatment only applies to accounts owned by a student or their parent. When a withdrawal is taken from a 529 plan owned by a grandparent or other relative it will be counted as income on the student’s next FAFSA. To prevent this, grandparents can hold off on paying tuition until after the student files his last FAFSA. 

Myth No. 6: I’m Too Poor (or Too Rich) for a 529 Plan

In January, the White House proposed taxing the earnings on 529 plans, claiming that only a few wealthy families use them. Yet according to data from Strategic Insight, 70% of families that use 529 plans have household annual incomes less than $150,000. The resulting public outcry led the president to quickly change his mind and revoke the proposal.

Many 529 plans offer minimum monthly contribution requirements as low as $25. This modest amount, combined with gifts from friends and family and the power of tax-free compounded earnings growth, can grow substantially over time.

And unlike Roth IRAs and Coverdell ESAs, which have fairly strict income and contribution limits, families of all income levels can enjoy the benefits of 529 plans. In fact, there are generally no annual contribution limits and deposits up to $14,000 ($28,000 for married couples filing jointly) will qualify for the annual gift tax exclusion.

Kathryn Flynn is content director of Savingforcollege.com. She has worked in the investment industry for over 10 years and brings a wealth of knowledge to her posts. She is a firm believer in the need for financial awareness and enjoys helping families understand the benefits of saving for college with 529 plans. You can follow Kathryn on Twitter at @saving4college and on Facebook.

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