Five 529 Plan Myths

Five 529 Plan MythsA 529 savings plan is a tax-smart way to save for your child or grandchild’s college education.  You can be ahead of the game by avoiding these five 529 Plan myths that could be costly.

Myth 1:  I must use the 529 Plan offered by my state of residence. FALSE

If you believed this to be true, don’t be too upset with yourself.  Fewer than 20% of people polled got this right the first time.  You can enroll in almost any state’s 529 plan regardless of where you live. The funds you save can be used in ANY college or program anywhere in the country – not just the state sponsoring the plan. Some states offer residents a state income tax benefit but there is no real built-in reason that you have to choose your home state’s plan.  In fact, if your home state’s plan is expensive, a poor performer or has insufficient choices for your taste, you may be better off crossing the border or crossing the country.

Myth 2: If my child doesn’t go to college, I’ll lose the money I have saved in my 529 Plan.  FALSE

Nearly 18% of parents and 10% of grandparents get this wrong.  If the beneficiary of your 529 Plan doesn’t go to college, fear not!  It’s your money and you can keep it in the account almost indefinitely.  You can change the beneficiary to another child or even a charity.  Ever wanted to set up a scholarship fund?  Well, you can and name it as the beneficiary.  You can even name yourself and use it later on if you decide to return to college or graduate school.  Many career-changers and even retirees consider going back to school so you can end up using your own money on yourself and not take a tax hit.

On the other hand, you can choose to take a non-qualified withdrawal, a distribution that is not covering ‘qualified’ education expenses like tuition, books or fees.  I’ve had clients who chose to withdraw funds to buy a car when it was clear that their grandchild wasn’t planning on attending college.  When they did this, they had to report the withdrawal on their tax return and pay a 10% penalty tax only on the earnings portion of the account.  You’ll never be taxed or penalized on taking back your principal (the amount you deposited) since these contributions were made with after-tax money.

Myth 3:  529 Plan savings must be used for colleges in the state where the plan is based.  FALSE

Your plan’s beneficiary – typically your child but just about anyone named on the account – can use 529 plan savings to pay for almost any post-secondary education program including traditional four-year universities, community college, trade or vocational schools and study abroad programs. Funds may be used at public as well as private educational institutions.  The only rule is that the school or program be accepted on the Department of Education’s list which you can find through this link.

Myth 4: If my child gets a scholarship, I’ll lose the money I have saved in the 529 Plan.  FALSE

If your student gets a scholarship, well, congratulations!  You get kudos for raising a kid who can beat the odds and win the favor of a scholarship committee.  And you get kudos because you don’t lose the money you’ve saved.  Your student can still use the 529 Plan to help fill in the gap for college funding.  You can make withdrawals up to the amount of the tax-free scholarship without any penalty.  If you take out more than the tax-free scholarship portion, the earnings portion of the withdrawal will be subject to income tax only.  To mitigate this possibility, delay using the 529 funds until years your child is not receiving scholarship funds.

Myth 5:  Savings in a 529 Plan are considered when determining financial aid eligibility.  SOMETIMES FALSE

If your 529 Savings Plan is owned by the student, then the asset will be assessed at 20%, the highest rate in the financial aid formulas.  Parent-owned 529 Savings Plans are also assessed but at a much lower rate – about 5.6% of all non-retirement assets above the ‘Asset Protection Allowance’ which is based on your family size and age of oldest parent.

The best option:  Grandparent-owned 529 Savings Plans (this also applies to plans owned by any other relative as well – preferably one who doesn’t have kids going to school).  Why?  Because such plans are not reported on the financial aid forms (FAFSA).

One thing to note is that when a grandparent or relative makes a withdrawal to pay tuition from the 529 Savings Plan th child must report this as “income” on the following year’s FAFSA.  While it’s not income for tax purposes, it is for Department of Education rules.  Sorry.  That’s just the way it is.

As student ‘income’ it is assessed at 50%.  This may not make a difference for a student who was not eligible for needs-based financial aid – the case where there is a high Expected Family Contribution (EFC).  But this could impact the eligibility of a student who is borderline or definitely qualifying for needs-based aid.

What to do?  Well, as long as the funds remain in the grandparent-owned 529 it won’t need to be reported.  So the best tip is to hold back from making any withdrawals until late in the college funding game – preferably waiting until after the last FAFSA financial aid form is filed.