Section 529 plans have become one of the most popular tools used by parents to save for their children’s college education. One reason they’re so “in” is their favorable tax treatment: If the funds are used to pay for qualified education expenses, the earnings accumulate tax-free.
However, some common misperceptions have arisen about Section 529 plans since they were first introduced in 1996. These have prevented some families from using them to full advantage.
Just the facts
Here are five common myths about Section 529 plans, along with some key facts:
Myth: My child can go to school only in the state where the plan is opened.
Fact: 529 plan funds can be used at any eligible college or university. There are even some qualifying foreign institutions where 529 funds can be used.
As long as the funds are used for higher education, you may be eligible to use your 529 plan — whether for a two- or four-year school, vocational-technical school or graduate school. But for 529 prepaid tuition plans (see “The lowdown on 529 plan types”), there’s more uncertainty about how plan benefits will be applied if the child attends a different school.
Myth: The money saved in a 529 plan may only be used for tuition expenses.
Fact: As long as the plan is a savings plan (again, see “The lowdown on 529 plan types”), there’s a wide range of college expenses the funds can be applied toward. These include room and board, textbooks, supplies, computers, software and Internet access. Expenses related to services for a special-needs student also can be paid with 529 funds.
Myth: If my child decides not to go to college, the money saved in the plan will be forfeited.
Fact: While 529 plans must fund qualified education expenses to retain their tax-advantaged treatment, you do have some options if your child doesn’t attend college. For example, the money can be used by another child who is attending college. Or you could use the money yourself if you go back to school.
If neither of these solutions works for you, you can withdraw the money you’ve saved in a 529 plan. But you’ll have to pay federal income taxes at your ordinary rate plus a 10% tax penalty on the earnings portion of the distribution. Note that the 10% penalty is waived if your child receives a college scholarship. (State tax consequences vary. If you received a state tax break for contributing, for example, you might owe state income tax on the entire distribution.)
Myth: Opening and contributing money to a 529 plan will make it harder to receive financial aid.
Fact: Technically this is true, but practically, the effects are minimal. Here’s why:
The money saved in a 529 plan will generally be reported as a parental asset on the Free Application for Federal Student Aid (FAFSA). But 529 savings only reduce eligibility for need-based aid by up to 5.64%. So if you have saved $10,000 in a 529 plan, your need-based aid would only be reduced by $564 at the most.
Myth: I can’t earn market-based returns on my 529 savings.
Fact: With a savings plan, you can invest in a wide range of vehicles to try to boost your returns. You’re limited to the investments the plan offers. But the options can include stocks, bonds and cash equivalents, as well as index funds that try to match the performance of a benchmark index, such as the S&P 500. If certain investment options are important to you, shop for a plan that offers them. Keep in mind that you can contribute to a 529 plan in a different state.
You also generally can choose an age-based asset allocation in which the mix of investments is automatically adjusted to reduce risk as your child nears college age. For example, riskier stocks might be replaced with more conservative bonds and cash equivalents once your child reaches age 15 or 16.
Don’t let myths or misperceptions keep you from realizing the benefits of saving for college expenses with a Section 529 plan. For more details on 529 plans, talk to your tax advisor.