6 myths about 529 plans

Four out of every 5 parents plan to help pay for their children’s college education, according to a poll commissioned by Discover Financial Services — but there’s a lot of confusion as to the best way to save. Long the favorite choice among investment advisers, 529 college savings and prepaid plans offer significant tax savings and financial aid benefits. But many families aren’t aware. A survey by Edward Jones shows that less than one-third of Americans could identify a 529 plan as a type of college savings vehicle, a figure that’s down 7 percentage points from the year before. Don’t worry though: We’re here to demystify the college savings process. Here are six misconceptions about 529 plans.

There’s only 1 kind

Actually, there are two basic varieties of 529 plans, according to the SEC. The 529 prepaid plans take a “buy now, use later” approach. Families can buy tuition “units,” which are typically priced based on the current average cost of tuition at public colleges in that state, then use those units years later when the student is ready to haul off to school. Provided the student attends a public college or university in that state, prepaid tuition plans can never decrease in value.

However, 529 college savings plans operate more closely to traditional investment accounts like IRAs and 401(k)s. All 529 college savings plans offer families an array of prepackaged investment portfolios, typically anywhere from five to 15 selections, which will increase (or decrease) depending on the markets. All states and the District of Columbia offer some form of 529 plan, but only 16 offer prepaid plans.

These 16 states offer prepaid college tuition plans

Colorado Michigan Tennessee
Florida Mississippi Virginia
Illinois Nevada Washington*
Kentucky New Mexico Wisconsin
Maryland South Carolina
Massachusetts Texas

*Washington is the only state on this list that doesn’t also offer a 529 savings plan.

Source: Finaid.org

Both types of plans allow savings to grow federal-income-tax-free as long as the funds are used for qualified education expenses. Some plans also come with state tax incentives, such as deductions or tax credits, but that varies significantly by state.

529 plans all cover the same expenses

The 529 college savings plans can be used to cover tuition, fees, room, board, books and a computer (if the school requires students to have one), but prepaid plans typically only cover tuition and fees. Some states, like Florida, offer separate programs to cover housing costs, but many don’t.

Many families also don’t realize that 529 funds are portable, says Daniel Reyes, principal and head of Vanguard’s education savings group.

“We often find ourselves answering the question about whether or not you have to go to college in the same state as the 529 plan that you use and the answer to that is no,” he says.

It’s important to note that while families can apply all funds in a 529 college savings program to any accredited school they wish, prepaid plans are designed for public colleges in the program’s home state.

Should the student with a prepaid plan attend a private or out-of-state college, families can always apply the amount they’ve invested toward college costs, but they could lose out on interest. Many plans will kick in a prorated amount of interest, but how much varies by state.

They’re only for 4-year college students?

Not so, says Pamela McNulty, senior director with TIAA-CREF Tuition Financing Inc., a full-service financial services organization that manages 11 state 529 plans.

“You can also use the funds at community colleges and technical schools,” she says. “It’s not just the four-year private or four-year public (schools).”

Both 529 prepaid and college savings plan funds also can be used at any accredited vocational or professional training institution, but attending unaccredited schools or certain foreign institutions (with some exceptions) won’t count. In those cases, families will have the option to either roll over their 529 cash to another beneficiary or withdraw their funds and pay back taxes, as well as a 10 percent penalty on plan earnings.

529 plans only offer tax and financial aid advantages

Also not true. Several states, including Louisiana, Missouri and Arkansas, offer matching grants to help give your 529 plan a boost. Grants are typically only reserved for plan holders who earn under a certain benchmark — that amount varies by state — and some grant funds are doled out on a first come, first serve basis, meaning it’s worth your while to investigate those options early.

Some state 529 plans also provide significant tuition discounts. For example, to open Florida’s prepaid college plan, either the account holders or beneficiaries have to have lived in Florida for at least the past 12 months before opening. Once opened, the plan allows beneficiaries to qualify for in-state tuition at Florida public institutions, regardless of where the student lives. The University of Alaska school system also offers in-state rates to students who have been the beneficiary on a state 529 account for at least two years.

529 plans are flexible

Compared with other investment accounts, 529 plans aren’t really flexible. Plan holders can only change their 529 portfolios once per year, reports the SEC, and funds can only be used for qualified education expenses without incurring a penalty.

“Let’s say you have a 529 plan and you have some sort of family emergency and you need to pull assets out of your 529 account,” Reyes says. “What happens at that point in time is it’s considered a non-qualified withdrawal. … You’ll pay income taxes on the earnings and you also pay a 10 percent penalty (on earnings only).”

If a student decides not to attend college, chooses to go to an unaccredited institution or heads out of the country to an institution that doesn’t qualify, account holders can either roll over their funds to themselves or another beneficiary in the family or they’ll have to pay back taxes and the penalty.

529 plans cost the same

Like other investment accounts, 529 plans each come with their own fees and commission structures, says Roger Michaud, senior vice president and director of the college savings program at Franklin Templeton Investments. Direct-sold plans cost less, but don’t offer active management by an investment professional. Broker-sold plans are actively managed but usually cost substantially more.

Direct-sold plans typically cost 25 basis points or below — that’s 0.25 percent of the value of the plan or less — but “depending on the program, I’d say the range (on broker-sold plans) is 20 to 25 basis points on up to that 1 percent level where that fund may be diversified both internationally in stocks and domestically as well,” Michaud says.

To figure out which plan is going to pay off the most, future 529 holders need to carefully evaluate the tax benefits, fees, investment options and performance history of several plans before settling on one, Michaud says.

“The winner isn’t always the low-cost provider,” he says.