Yesterday I wrote a post detailing what I thought were some of the best 529 college savings plans available. We briefly talked about what a 529 plan was, and what is important when choosing one for your education savings.
While we briefly talked about some of the pros and cons of 529 accounts, we didn’t get very deep into what some of the myths about 529 accounts are, because there are quite a few. While 529 accounts have been around since the 1990s, there are still quite a few misconceptions that people have about 529s, and it can prevent them from maximizing their savings in the long run.
So today, we’re going to look at a few myths about 529 college savings plans.
What Is A 529 Plan?
Let’s start with a little background. 529 plans are so named because they are found in section 529 in the Internal Revenue Code. They were passed back in 1996 as a way to encourage families to start saving for their kids college education. There are two types of 529 plans. 529 college savings plans, and 529 prepaid plans. For the purposes of this article we’ll focus on the one I prefer, the college savings plan, because it’s more flexible and will give more options to the most people.
529 college savings plans are a tax advantaged savings plan that allows you to invest or save, and then any earnings you get are tax free as long as they’re put towards the cost of education. You can find 529 plans through a variety of sources, and each one will have it’s own slate of investing and saving options, so it’s important to do your research and choose the right one for your family.
So what are some common misconceptions about the 529 college savings plan?
Myth – You Have To Invest In Your State’s 529 Plan
Because states have their own 529 plan people automatically assume that they’re only eligible to invest in their own state’s plan. They also at times get confused between 529 college savings plans and 529 prepaid plans. With the 529 prepaid plans, once you have prepaid for tuition, you are often tied to schools in that state.
With 529 college savings plans you aren’t tied to your state plan. The only reason that you might want to stick with your state’s plan is in case it’s one of the better low cost plans available, or if your state is one of the ones that offers a state income tax deduction for contributing to a 529. If there is no deduction, or if the plan is a higher cost plan, you can always look to other state’s 529 plans for a better option.
Myth – Your Child Has To Attend College In The State Tied To Your 529
People often assume that when they buy into a 529 plan, their child will have to attend school in that state. That is false, and may be because people are confusing 529 prepaid plans with college savings plans. Prepaid plans often require students to attend in state, or at least have some exclusions to attending out of state.
A 529 college savings plan is completely portable, and the assets can be used for college expenses in any state, and even at some universities abroad. So no worries about having to attend school in Utah if your plan is located there.
Myth – State Tax Deductions Only Available For In-State 529 Plans
Most people assume that they can only get a state tax deduction (if their state offers one) if they contribute to their state’s 529 college savings plan. While that is often true, there are several states that will offer a deduction when you contribute to any 529 plan.
Arizona, Kansas, Maine, Missouri, and Pennsylvania all have state income tax deductions for 529 plan contributions when residents contribute to any 529 plan, not only the one for their state. So if you live in one of those states, congrats, you’re all set!
Myth – All 529 Plans Are Basically The Same
529 plans often seem to be pretty much the same thing on the surface, however, if you look under the hood the plans often have major differences. Fees, investment options, investment strategy and more can all be quite different depending on which plan you choose.
The biggest thing that can hurt your earnings is the fees charged by your plan, so it’s important to do some homework before you choose a plan to make sure that the one you choose is a good one. Here’s a look at some of the best 529 plans for 2012.
Myth – You Lose The Money If Your Child Doesn’t Go To College
Some people believe that if your child doesn’t end up going to college that the funds in the 529 will be lost, or be subject to penalties. Fortunately you will never lose the money in your 529 savings plan account completely, but if you do decide to cash it out you will be subject to taxes on the earnings, in addition to a 10% penalty.
Thankfully there is another option. You can always transfer the 529 if it isn’t used – or if it isn’t used completely – into the name of another beneficiary. People you can transfer to include yourself, siblings, first cousins, parents, grandchildren, aunts and uncles, and even in-laws. So you should have a good option of somewhere in there to transfer the funds to.
If your child becomes disabled, dies, or gets a scholarship, the 10% penalty on your 529 account can be waived, although taxes are still due on earnings.
Myth – A 529 Hurts Financial Aid Prospects Of The Child
While this one isn’t completely a myth, as a 529 can hurt financial aid prospects a bit, the impact of being a beneficiary on a 529 plan has much less impact than directly student owned assets. Morningstar explains:
non-529 student-owned assets carry more than 3 times more weight in financial aid calculations than do assets held in the parents’ names.
The impact a 529 has on financial aid calculations is relatively minor, and shouldn’t be considered a big factor. If you’re really worried about this, you may want to consider saving for college in a Roth IRA.
529 Plans – A Good Way To Save For Education
So as you can see 529 plans are a pretty good way to save for college education. If offers a tax advantaged way to save for educational expenses, in some states it offers a tax deduction, and in general it means you’re helping your child to start their future off on the right foot – with less or no school debt.
What other myths are out there about 529 plans? Tell us what misconceptions or questions you have about 529 savings plans in the comments.
We have the Nevada 529 plan even though we live in Indiana and have been very happy with it. Money is automatically withdrawn each month from our checking account making deposits effortless and just like paying a bill.
DC @ Young Adult Money says
I actually didn’t know that they varied much from state-to-state, nor did I know you could invest in other state’s 529 plans. Looks like this post was made for people like me who are clueless about the 529 plan ;)
I have never understood why you’d go with a 529 instead of normal investing – the potential drawbacks seem a lot bigger than the few upsides, at least for our family :)
If you start while the children are young enough, the big benefit of saving in a 529 vs. “normal” (taxable) investing would be tax-deferred growth. If you save in the 529 and spend the account on qualified expenses, you won’t pay tax on any of the growth. Compared to getting chopped down by your marginal tax rate every year, that’s a significant advantage over the long (but only if you start early enough to get any growth).
Mario Adventuresinfrugal says
I was speeding through agreeing with you, but nearly choked on my water when I got to the part about it not affecting financial aid. Glad to see you cleared that up :)
A few notes about using a Roth IRA for college savings:
For people applying for (and expecting to receive) financial aid, using Roth IRA contributions to pay for college only makes sense during the final year of college. Here’s why:
A 529 plan owned by a college students or his parents counts as an asset and reduces need-based financial aid by a maximum of 5.64% of the asset’s value.
Alternatively, the entire Roth IRA distribution must be included as income on the student’s federal financial aid application for the following year, which could result in significantly lower financial aid.
I like just about everything regarding the 529, however, my only concern is that I would be ASSUMING my daughter will be attending college, a choice which is ultimately up to her. There are lots of other things she may want to do instead. In my particular case there is no one else to give the 529 money to and even if there was, do I really want to give all that money i have saved for 18 years to my brother’s kids?