Five misconceptions about 529 plans and qualified educational expenses
Even though it’s been around for 21 years, many people still don’t know what a 529 plan is.
Seven out of 10 Americans couldn’t identify the taxadvantaged savings account, according to recent findings by financial services firm Edward Jones.
Under a 529, if the money is used for qualified educational expenses, your earnings are tax-free.
I think part of the reason this savings vehicle isn’t widely known stems from a number of misconceptions about how it works. So let me do some mythbusting in honor of National 529 College Savings Day, which falls each year on May 29.
To help, I’ve asked Mark Kantrowitz, my go-to guru about paying for college. Kantrowitz is publisher of Cappex.com, a free website about college admissions and financial aid.
Here are five common misconceptions about 529s:
1. Contributing to a 529 will hurt my child’s chances for financial aid.
I’m always perplexed by this notion, since most federal aid comes in the form of loans. Sure, there’s a bit of truth to the statement but not enough that it should stop you from saving in a 529 plan.
As Kantrowitz points out, if a dependent student or the custodial parent owns the account, it is reported as a parental asset on the Free Application for Federal Student Aid (FAFSA). The savings reduces eligibility for needbased aid by a maximum of 5.64 percent.
“If you save $10,000 in a parent-owned 529 plan, needbased aid will be reduced by, at most, $564,” he said. “That still leaves you with $9,436 available to pay for college costs. The college savings provides the flexibility to choose a more expensive college than you otherwise could afford. It also reduces debt, since every dollar you save is a dollar less you’ll need to borrow.”
2. A 529 plan means my child is limited to going to a school in the state where I open the account.
You can use money saved in a 529 to pay for college costs at any college or university that is eligible for Title IV federal student aid.
“You can even use 529 plan money to pay for college outside the U.S. at one of a few hundred eligible institutions,” Kantrowitz said. “You can use 529 plans to pay for two-year and four-year colleges, as well as certificate programs and vocational-technical school. You can even use the money to pay for graduate school.”
3. The returns in a 529 plan are lousy.
“All 529 college savings plans include an S&P 500 investing option that will mimic the performance of the stock market as a whole,” Kantrowitz said. “However, since the stock market will drop by 10 percent at least two to three times in any 17-year period, it is smart to manage the risk by using an age-based asset allowance. Like a target-date fund, an agebased asset allocation shifts the mix of investments from aggressive to conservative as college approaches.”
Here’s something else to keep in mind. Your state may give you a deduction for 529 contributions up to a certain amount. Vanguard has an online calculator that estimates what you could deduct (vanguard.wealthmsi.com/ stdc.php).
4. You can use money in a 529 plan only for tuition.
Nope. In addition to room and board, the money you save can be used to pay for books, supplies and equipment,
including a computer, peripherals, software and Internet access. You can even pay for expenses for specialneeds services. 5. I’ll lose my money if the beneficiary doesn’t go to college.
If the beneficiary doesn’t pursue a higher education, you have options because the money is yours. You can switch the beneficiary to someone else, including yourself.
But let’s say there isn’t anyone else you want to give the money to or who needs it. You can withdraw the funds, but you’ll have to pay ordinary income taxes and a 10 percent tax penalty on the earnings portion of the distribution if the money isn’t used for qualified education expenses. By the way, the 10 percent penalty is waived if your child gets a scholarship.
For more on this topic, read Kantrowitz’s blog post “Most common college savings mistakes” at Cappex.com.
Some parents tell me that they haven’t set up a 529 because they believe their child will win enough money in scholarships.
Reality check: The average scholarship amount is just under $4,000 a year, according to Kantrowitz’s research.
“Less than 1 percent of students win a completely free ride through scholarships,” he said.
Maybe your child will beat the odds. But do you want to take that chance? Invest in a 529 plan, because hoping is not planning.
“You can use 529 plans to pay for two-year and four-year colleges, as well as certificate programs and vocational-technical school. You can even use the money to pay for graduate school.” Mark Kantrowitz, Cappex.com