The 3 biggest misconceptions about 529 plans

Most parents have every intention of saving for their child’s college education – and as early as they can. But putting money aside for an expense that’s years away can easily be bumped lower on the list of priorities, especially when you’re confused about the best way to go about it.

Of the parents that do try to save, many are bogged down by misconceptions that are costing them. As a result, too many are stowing money away in their savings accounts and 401(k)s rather than using 529 plans that reduce the amount you lose to taxes.

In a recent survey by T. Rowe Price, nearly half of parents said they are using a regular savings account to save for college. And while 31% said that they are using a 529 account, 28% said they don’t even know what a 529 plan is.

If you’re among those not in-the-know, here’s the deal: 529 plans are investment accounts that let savings grow tax-free, and earnings are completely tax-free if withdrawals are used for qualified college expenses; these plans have no income limit, and many states’ 529 plans give parents a tax credit or deduction for contributions.

Stuart Ritter, certified financial planner and vice president of T. Rowe Price Investment Services, hears from parents who want to do what’s best for their families, but are often misinformed.

Here are three of the biggest misconceptions causing the most confusion about 529 plans:

#1 Misconception: Saving for college will hurt how much financial aid you receive

“A number of parents mistakenly believe that every dollar you save is a dollar less you’re getting in financial aid – and that's not how it works,” says Ritter.

When you apply for financial aid, only 5.6% of what you saved as a parent is factored into the expected family contribution (EFC), which is what a college will expect you to pay for one year at your child’s school. So if you have a thousand dollars saved, it means about $56 less in financial aid. With soaring college costs, T. Rowe Price says you’ll need to save $450 per month from the time your child is born to pay for the total cost of an average public college, which is projected to cost more than $200,000 according to a calculation by T. Rowe Price.

#2 Misconception: Money saved in a 529 can only be used for education

You will always have control over the money even if you decide to use it for something other than an educational expense. There will, however, be a 10% penalty on the earnings from the fund, for a non-qualified withdrawal.

Money in 529 accounts can be used for undergraduate or graduate studies at any accredited two- or four-year university. This includes tuition, fees, room and board, computers, and textbooks.

If you’re lucky enough to have money leftover after paying your child’s tuition expenses, you don’t have to forfeit the funds. To avoid tax penalties, you can change the designated beneficiary, or roll over the funds to another member of the family.

#3 Misconception: You can only use your own state’s 529 plan

Some people think you can only choose from your state’s available 529 plans. Not the case. Start by checking your own state’s plans because many states give their residents additional tax breaks for using their own plans, but you can choose from any state’s options.

So even if you may decide on transferring your funds to a different 529 plan down the line, it’s important to start saving in any 529 plan right away, says Ritter.

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