Even though they’ve been around for decades, 529 college savings plans are still often misunderstood.
The investment vehicles are a tax-advantaged way to save for college or other schooling. Earnings are free from federal tax and the funds aren’t taxed when taken out to pay for qualified expenses.
Yet only 36% of Americans can correctly identify the plan as an education savings tool, according to a recent study by Morning Consult Edward Jones.
“It can be overwhelming,” said Michael Conrath, head of education savings for J.P. Morgan Asset Management.
It can also be confusing. Not only are different options available, there are several misconceptions about how the plans work, as well the extent to which financial aid and scholarships actually pay for school.
The reality is only 0.3% of students receive enough grants and scholarships to cover the full cost of college, Conrath said.
“You can’t let your own scholarship dreams get in the way of the reality that you likely need to invest right away,” he said.
Here’s a look at some other facts parents get wrong about 529 plans.
Each state offers a 529 college savings plan, but you don’t have to choose the one offered by your home state or the one in which your child will attend school.
However, you may be able to take advantage of a state tax break by contributing to your own state’s plan if one is offered.
To choose a plan, look at the fees involved, the plan’s manager and its track record, and what it is invested in — and how it fits into your time horizon, Conrath said.
Conrath has heard parents say they worry “a 529 will clobber my chances of getting aid.”
In reality, it will reduce a student’s aid package by a maximum of 5.64% of the plan’s value — and that’s after the approximately $10,000 that falls under the Asset Protection Allowance, according to SavingForCollege.
A college fund in a bank savings account or certificate of deposit also reduces the aid package by 5.64% of its value. However, you get a better return on your investment in a 529 plan, Conrath points out.
Qualified expenses include college tuition, room, board, fees and books. You can also use the money for computers, printers and internet service, as well as graduate schools, trade schools and apprenticeships.
In addition, you can pay off up to $10,000 of qualified student loans with your 529 funds over your lifetime, and pay up to $10,000 a year for tuition for your child’s K-12 private school.
If your child doesn’t end up using the money, you can change the beneficiary to another qualified family member, such as another child, sibling or spouse.
Even if no one uses it, you can withdraw your money. Your initial investment comes out tax- and penalty-free, since you already paid taxes on it before depositing it, said Dorethia Kelly, founder and CEO of finance website Money Chat and office decor and careers site Work, Space, Spark.
Any earnings are subject to a 10% withdrawal penalty.
“At the end of the day for a parent, you’re still coming out ahead because you’re getting your money back,” said Kelly, author of ”#MoneyChat THE BOOK: How to Get Out of Debt, Successfully Manage Your Money and Create Financial Security.”
The earlier you start, the more money you can save. However, even if you wait until your child is in high school, it’s better than nothing.
“Whatever you save for the next two years will help with books or something,” Kelly said. “All that adds up.”
In fact, you can keep contributing to the account while your child is at school — so if you saved for four years during high school and another four during college, you have an eight-year investment horizon, Conrath noted.
Ultimately, you’ll wind up with more money in the tax-advantaged account, as long as you use it on qualified expenses.
If you open a 529 plan with $10,000 when your child is born, consistently deposit $500 a month for 18 years, assuming you get a 6% hypothetical return, you will have nearly $220,000 to spend, he said.
Without the tax average, you’ll wind up with $172,000, he said.
“The biggest thing is just if you are thinking about it, you need to get started today,” Conrath advised.