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COLLEGE SAVINGS 101

7 myths and realities of 529 plans

Erin Peterson is a freelance writer based in Minneapolis.

by Erin Peterson

Although 529 college savings accounts have been around for years, there are common misconceptions about the plans. Learn the truth behind these seven myths and you'll set yourself up for smarter college investing.

Myth 1: If my child doesn't go to college, I lose all the money in my account.

Reality: A 529 plan has more flexibility than you might imagine, says Russell Dunkin, certified financial planner at McKinley Carter Wealth Services in Wheeling, W.V.

"First, 529 plans can be used for almost any post-high school education, like trade or technical schools -- even PGA golf professional schools. Don't get trapped into thinking it's only for the traditional undergraduate experience," he says.

"Furthermore, you can transfer the assets to a sibling or even yourself," Dunkin says. If you don't like either of those options, you can pull out the money with a nonqualified withdrawal, but you will have to pay taxes on the earnings as well as a 10 percent penalty.

Myth 2: If my brilliant or athletic kid gets a full ride, I lose the money in my account.

Reality: As with the previous example, you can transfer the money to another beneficiary. But if your kid's so talented that colleges are willing to pay to get him or her in the door, you won't be heavily penalized, says Mary McConnell, director of college savings products for Charles Schwab in San Francisco. "If a child gets a scholarship, the penalty for making nonqualified withdrawals is waived, and there will be income tax only on the account's earnings."

Myth 3: I can only invest in my state's plan.

Reality: You can invest in any 529 plan from any state, but there's a good reason that most people choose to go with a plan offered by their state, says Dan Danford, chief executive officer of Family Investment Center, an investment management firm in St. Joseph, Mo.

"Many states give you a state income tax break if you use the plan offered by your home state," he says. "If you don't like the plan your state offers, you may not get the state income tax breaks, but you still get all the benefits of tax-free accumulation and withdrawals."

A few states, including Arizona, Kansas, Maine, Pennsylvania and Missouri, will even give you a state income tax deduction if you choose a 529 plan not offered by your home state.

Myth 4: My child can only go to college in the state where the plan has been set up.

Reality: You are free to use the 529 savings almost anywhere -- inside and outside your state, says McConnell.

"There is no restriction or requirement to use 529 assets for a school (in a state) in which the taxpayer or beneficiary resides," she says. "People can use that money for qualified expenses for any school that's been accredited for financial aid, and that includes many international programs."

Myth 5: Only young people can have 529 plans.

Reality: Anybody can have a 529 plan, whether they're 8 years old or 80 years old. Savvy people can use this information to save on their own continuing education, says Danford.

"If I know I'm going to spend $5,000 on tuition this year for a doctoral program, I can deposit the money in a 529 plan, take my state’s tax deduction and then withdraw the money soon after," says Danford. "There's nothing wrong with that. The whole idea is to encourage people to put money aside to go to school, and if people are going to school, the plan is serving its purpose."

Myth 6: I won't get financial aid if my child has a 529 account.

Reality: A 529 plan is calculated into the financial aid equation but has a smaller impact than most people realize, says Dunkin.

"The assets within a 529 plan are considered parents' assets, which are factored in the financial aid calculation at a much lower percentage than a child's assets," he says. Up to 5.6 percent of these assets may be used to pay for college costs, but compared to other popular college savings tools like custodial accounts or UGMAs, also known as the Uniform Gifts to Minors Act, 529 plans are a very good option. Because UGMA custodial accounts are considered student assets and not parental assets, they are assessed at a rate of 20 percent.

Myth 7: My income is too high to contribute to a 529 plan.

Reality: Many people assume that the same rules that dictate income limits for IRA accounts or other savings vehicles also apply to 529 plans. This simply isn't true, says McConnell.

"There are no income limits that regulate how much you can contribute," she says. In fact, high-income earners may have an advantage. Thanks to special gift-tax exclusions, a married couple can contribute up to $130,000 to a child's 529 account in a single year without incurring any gift tax.

Posted April 9, 2010