What is a 529 plan? Myths vs facts

You love your kids beyond words. It's why you naturally seek out the best for them. But it's hard sifting through all the parenting advice you hear. How can you separate the facts from the myths? That depends. Are we talking kid-friendly vacation suggestions from your best friend? Probably trustworthy. How your mom got you to eat your veggies? That's a definite. Important college savings questions like "What are 529 plans and how do they work?" Well…

What is a 529 plan?

As it turns out, half of Americans (50%) don’t know what a 529 plan is and fewer have this type of account.¹ Why? Because you usually only hear about these types of things from a financial advisor. Unfortunately, the average American might not have one of those, so let's clear up the rumors. A 529 plan is an investing tool that makes it easier to pay for college. It helps you save money in the bank now while still providing for your child's future.

They're officially called "qualified tuition programs" (QTP) but are nicknamed for (and authorized by) Section 529 of the Internal Revenue Code.² Feel free to call them whatever you like as long as they save you some money!

How do 529 plans work?

You can learn more about how 529 plans work here, but what you need to know in order to bust some myths is simple. There are 2 different types to choose from: 529 prepaid tuition plans and 529 college savings plans.

• What is a 529 plan for prepaid tuition? These plans are offered by states and private colleges. They let parents lock in current tuition rates at participating universities and slowly pay them off. This helps you save money since you're protected from the average annual tuition inflation rate, which was 12% from 2010 to 2022.³

• What is a 529 plan for college savings? These investment plans are offered by states. They let you choose from several mutual fund options to put cash into, including stocks and bonds. You can save big because any earnings you make aren't subject to federal tax—as long as you use the money on college costs. Many states also waive state taxes, and some even offer write-offs for the money you put in, which equals more savings.

But right about there is where the clarity stops and some of the confusion begins. So, how do 529 plans really work? Time to bust some myths.

Myth #1: Having a 529 plan cuts your financial aid so it's actually a waste of money.

Fact: Kids generally only lose about 6% of their financial aid due to 529 plans.⁴

Do 529 plans affect financial aid? Yes. Just like CDs, brokerage accounts and a few other types of financial assets you may have, they do. But it's probably not a deal breaker—especially since the money you save with a 529 can easily outweigh any potential financial aid loss. Remember:

• Financial aid is based on your assets, or how much money a family has to help pay for college.
• Almost all college savings impact how much aid your child is eligible for, 529 plans included.
• FAFSA calculates your assets into an Expected Family Contribution (EFC) number.
• Typically the higher your assets, the higher your EFC, and the less financial aid your child gets.
   

The financial aid reduction caused by a 529 plan depends on who holds the actual account. As long as you (the parent) started the account and your child is listed as a beneficiary (not account holder), it's considered a parental or family asset. Without getting into how FAFSA treats assets too much, that works out to a 5.64% hit to financial aid.⁵

To put that into perspective, if your 529 plan has $10,000 in it, your child would only lose $564. They would still get over 94% of the financial aid they qualify for. Not bad, considering the savings from a 529 plan can easily offset such a minor loss.

For instance, if your plan lets you write off contributions, you could easily cancel out that lost financial aid in the first year alone. Just keep in mind that if your child or another family member is the account holder instead of you, the 529 impact to financial aid could go as high as 20%.⁴

Myth #2: If a 529 plan isn't used for college, you take a huge loss.

Fact: There are many ways to use your 529 money if things don't go according to plan.⁶

You're probably already experiencing it. Kids can have a mind of their own. Luckily, 529 plans have rollover rules and other options built in. Here are a few possible scenarios:

• Your future genius gets a full ride. Does a 529 plan affect scholarships? Nope. 529 plans and scholarships are 100% compatible. In fact, if your child's scholarship means your 529 money isn't needed, you don't have to pay the normal 10% penalty fee for not using the 529 money on college. You just pay the back income taxes at your regular tax rate and then withdraw the unused money. You can still pass those savings on to your child, maybe for a car or as a down payment on their first home.⁶ For partial scholarships, speak with your 529 plan manager.

• Your oldest skips college for the workforce. If your child doesn't go to college (or has leftover funds after college), 529 plan rollover rules can benefit your other children. Simply name your next oldest child as the beneficiary and let them take advantage of those savings. There's no tax penalty either, so your entire fund is still intact and usable.⁶

• You don't have a second child, but know someone who's college-bound. How do 529 plans work if you only have one kid? Simple. You can name any U.S. citizen with a Social Security number as a beneficiary for 529 college savings plans, including yourself.⁶ Once again, the money you've saved over the years is safe and yours to use.

• You need the money for something else. If your 529 plan is not used for college and you'd rather put that cash somewhere else—maybe in a money market account earning interest—just pay the 10% penalty fee and back income taxes. Then do what you want with the money you've saved up.⁶ Take that dream vacation, maybe remodel the kitchen or put it toward your retirement savings.

Myth #3: You're only allowed to have one 529 plan.

Fact: Your child can have multiple 529 plans.⁷

Ah, the age-old question: How many 529 plans can I have? Well, how many do you need? The fact of the matter is that your child can have 529 plans in different states, no matter where you live.⁷ Even more important is why you'd want to have more than one 529 plan. Here are a few possible reasons:

• Age. If your kids were born many years apart, it might make sense to open more than one 529 to make sure each one has a plan that invests based on their age. Plans that account for your child's age at startup invest more aggressively while they are young and then more conservatively as they near college age in order to get the best returns. It's kind of like a 401(k).⁸

• Timing. On the flip side, having two 529s can also be helpful if your kids are in college at the same time. College costs are only waived for the beneficiary of the 529. If you're using the same 529 for a second, unnamed child, their costs would incur a 10% penalty fee unless he or she was the beneficiary of a separate account.⁸

• Diversity. A 529 prepaid college tuition plan only covers tuition and fees, so having a second 529 college savings plan for costs like books or housing can help you cut out-of-pocket expenses.⁷ That's more money to save for other things—like a plane ticket to visit when they're homesick.

• Savings. Similarly, if you're going to open a 529 prepaid college tuition plan at a private college, having a 529 college savings plan as well (either in your state, the college's state or both) can help you save even more money through added tax benefits.⁷

• Limits. 529 plans do have contribution limits, even though most are very high. Still, if we're talking undergrad, grad school and then medical school, having multiple 529 plans means there's virtually no contribution limit.⁷ Generally speaking, more money invested in your 529 college savings plans means higher earnings and savings in the long run.⁷

So the next time you come across some questionable advice, you know what to do: Take a closer look at the source. For questions like "what is a 529 plan" and other savings advice, turn to a trusted name in savings. Your child's future is that important.