The biggest misconceptions about using 529 plans to save for college

529 plans — tax-advantaged investment vehicles meant to help families save for college — are often misunderstood. 

As a result, many families may be missing out on a significant savings opportunity. That's because savings in a 529 plan grow free from federal income tax, and withdrawals for qualified expenses are tax-free. Some states also offer similar tax advantages.

Here are six common misconceptions about these plans:

No. 1: Only parents can invest

People mistakenly believe that only parents can invest on behalf of a child, but that's not the case. Grandparents, aunts and uncles, or even someone unrelated can open an account on a child's behalf or contribute to that child's account, said Rachel Biar, assistant state treasurer of Nebraska who chairs the College Savings Plans Network, a repository for information about 529 plans.

Family members could consider contributing to a 529 plan for a child instead of buying toys or other trinkets for birthdays and holidays. To make it easy, many 529s provide family and friends the opportunity to contribute to an account online, through the mail or over the phone, said Michael Frerichs, Illinois State Treasurer. 

Just keep in mind that for states that offer an income tax deduction or credit, the account owner is typically the one who can claim that benefit, Biar said.

No. 2: Can only be used at a traditional four-year college

Chances are, your child will need some type of post-high school education and 529s can be used at a range of other schools and training beyond four-year colleges and universities. Notably, funds don't have to be used at an in-state school. 

In October 2021, 61.8% of high school graduates ages 16 to 24 were enrolled in colleges or universities, roughly on par with year-earlier figures, according to data from the U.S. Bureau of Labor Statistics. Among recent high school graduates enrolled in college, seven in 10 attended four-year colleges. 

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Beyond four-year schools, 529 plan funds can also be used at eligible graduate schools, community colleges, two-year schools, vocational or technical schools and certain apprenticeships. Families can use government online resources to determine whether a school qualifies as an eligible educational institution, and to help students identify whether an apprenticeship program they are interested in qualifies for 529 plans.

Funds in a 529 plan can also be used to repay up to $10,000 in student loan debt. 

No. 3: There's too much risk the money will go to waste

If there's leftover money in the account, a family member of the current beneficiary can be named without tax consequences, said Mary Morris, chief executive of Virginia529 and vice chair of the College Savings Plans Network. The definition of a family member is broad and includes the beneficiary's spouse, child, sibling or step-sibling, parents, aunts and uncles, nieces, nephews and first cousins.

"It can go up and down the family tree," Morris said. "You have a lot of flexibility."

At worst, the owner can withdraw the funds and pay taxes and a 10% penalty on the earnings portion of the account, she added.

No. 4: It will ruin my family's financial aid application

Parent-owned 529 plans are treated more favorably than student-owned assets, so while there could be an impact on aid, it will be minimal compared with the savings potential, Biar said. "It's not enough to discourage people from saving," she said.

For parents who save more than the allotted $10,000 allowance, a maximum of 5.64% of parental assets will be counted, compared with a 20% rate for student assets.

If grandparents own the 529 account, it's not considered income to the beneficiary for financial aid purposes until a withdrawal is made, Biar said. A workaround for students graduating in four years — based on how income is reported on the Free Application for Federal Student Aid — is to use the money from the grandparent's 529 account after Jan. 1 of the student's sophomore year of college. If the student plans to graduate in five years, the distribution can be made after Jan. 1 of his or her junior year to avoid financial aid impact.

No. 5: It's useless if my child gets a scholarship

Scholarships can help defer higher-education costs, but a 529 plan can be used in conjunction with them.

Often, scholarships can only be used for tuition, whereas 529s can be used for books, room and board and other qualifying expenses, Biar said. Leftover funds in a 529 account won't be lost since another relative can be named as beneficiary.

No. 6: Now is a bad time to start saving for college

During market turbulence, people may feel concerned about their investments tanking, or conversely, when markets are doing especially well, they can be nervous about buying too high.

The reality is, you can't time the market and now is always a good time to start saving, Frerichs said. There are multiple investment choices based on risk tolerance and time horizon, and over time, you can benefit from compounded earnings. Even ultra-conservative investors can participate. Some plans offer FDIC-insured options, for instance.

"The best day to start saving for college is yesterday. The second best day to start saving for college is today," Frerichs said.

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