3 529 Plan Misconceptions That Trip Up College Savers

U.S.News & World Report

Florida parent Todd Smith recently opened a college investment account for his one-year-old daughter Bayley. He debated opening a 529 plan, as these tax-advantaged education accounts are known, for her because he had a few fears.

He had initially thought he would have to pick his state's plan and use the 529 plan for her to attend a school in Florida. He also thought he'd incur federal tax penalties if she chose a college outside of Florida or she received a college scholarship. Since Smith and his wife are both athletic, he felt it was likely Bayley could try for an athletic scholarship.

[Here are four reasons to consider buying another state's 529 plan.]

All of Smith's fears were put to rest when he researched 529 plans, but his misconceptions aren't uncommon. A survey released this year by Savingforcollege.com found that 70 percent of those surveyed didn't have a college investment account for their children. About half claimed a lack of time to research plan options was the reason why they hadn't opened an account. Families who didn't have an account had more misconceptions about plans, largely because they hadn't researched them.

Parents and college savers shouldn't fall for these three myths commonly cited by parents in the survey.

1. The student will assume control of the account. Some survey respondents believe their children get a hold of the money when they reach a specific age, between 18 and 21, like a Uniform Transfers to Minors Act account, says Hurley.

UTMAs can either be investment or savings accounts that are held by adults and automatically controlled by the adult who opened it until a child reaches the age of maturity. But with 529 plans, the account owner always maintains control.

The student is listed as a beneficiary who can use the money to pay for for his or her education. The name can be switched later to another person, such as a younger sibling, if the account owner chooses to do so. About two out of five survey respondents without 529 plans answered this question incorrectly.

[Learn to weigh 529 plan ratings when selecting an account.]

2. Families have to pick a plan from their state and use it for a school in the state. Not only did more than one in five respondents without 529 plans believe they had to pick a plan offered through their state, but a similar number thought they could only use the money at colleges in their state. Both of these misconceptions are untrue.

However, one reason why the misconception exists is that many states that do have a state income tax offer a state income tax deduction for 529 plan contributions that are only offered to taxpayers who own a plan in their state.

However, Smith -- who lives in Florida, which does not have state income tax -- initially fell for this myth for a different reason. Florida offers two plans: a prepaid tuition plan, a special kind of 529 plan that allows the account owner to purchase guaranteed tuition certificates at Florida schools, and a standard 529 plan.

He chose the regular 529 plan. But if he had chosen the prepaid plan, he still could have used the funds at schools located outside of Florida. There just would have been a different redemption value.

[Watch for possible changes to state's college savings tax benefits.]

3. Families will lose all the money in a 529 plan if the child decides not to go to college. This is far from true, though nearly 1 in 5 survey respondents without 529 plans believed it. If the child doesn't go to college, the money can generally be transferred without a fee to another beneficiary including the parent who might want to return to school.

The money can also be withdrawn if no one is able to use the funds, generally with a tax penalty. However, a tax penalty is a lot better than losing 529 plan savings completely.

Families need to take some time to develop a better understanding of the rules of 529 plans, Hurley says. The trick is to not expect 529 plan customer service agents to explain all the rules. It's hard to give the right answer, when someone doesn't know the right question, he says. Instead, he suggests families read the official program disclosure before they call.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

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