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T. Rowe Price’s recent Family Financial Trade-offs Survey revealed that almost half of parents who are saving for college (45%) are saving using a regular savings account, while only 31% are using a 529 plan. Lack of awareness seems to be the primary reason for this discrepancy—when asked why they were not saving in a 529 plan, 28% of parents said they didn’t know what it was. Those who have heard of a 529 plan often think it is too good to be true or that there must be some kind of catch. A 529 plan offers significant advantages when it comes to saving for college. With many competing savings priorities, parents should take a close look at all their options.
Here are three of the most common misconceptions about 529 plans and the reality about each.
MISCONCEPTION #1: A 529 plan won’t allow me to access my money if I need it; and if I don’t use it, I’ll lose it.
Our survey found that one in every four parents who is saving for college but not using a 529 account is concerned about having access to their money. In addition, almost half of parents think that if the money in the account is not used for college, it’s lost.
Reality: A 529 plan offers significant flexibility, and you can access the money at any time, for any reason. The money is always yours and stays in the account until you withdraw it. You don’t ever “forfeit” it. If the beneficiary listed on the account doesn’t go to college or, for any reason, doesn’t use all the money, you can change the beneficiary on the account to a relative of the beneficiary, such as a sibling, a cousin, or possibly even yourself, and use the money for them—without any penalty. For 529 college savings plans, the money can also be used for higher education expenses other than undergraduate tuition, such as graduate school tuition, room and board, books, and supplies.
If you do need to withdraw funds for anything other than a qualified educational expense, you’ll need to pay income taxes on those earnings, as well as a 10% penalty on the earnings. But, what’s important to remember is your contribution portion is never taxed or penalized. For example, let’s say you contributed $5,000 to your child’s 529 plan and it earned $2,000, giving the account a balance of $7,000. If you withdraw all $7,000, only the $2,000 of earnings would be subject to taxation and the 10% penalty (remember: the earnings haven’t been taxed while they were in the account). If you are in the 25% tax bracket, this would mean paying 25% + 10% of the $2,000 in taxes and penalties, or $700—leaving you with $6,300 to spend. Considering you invested $5,000, in this hypothetical scenario, you’re still left with significantly more than you contributed to use for anything you want.
MISCONCEPTION #2: I can only use my state’s 529 plan, and if I do, my child can only attend a state school.
Reality: The money saved in a 529 account can be used at almost any private or public college, university, graduate school, vocational school, or trade school anywhere in the country, not just the state you live in or the state sponsoring the plan in which you invest. Some international schools qualify as well. Of course, the specific plan may have residency requirements, but generally you can invest in any 529 plan and use your savings just about anywhere.
MISCONCEPTION #3: Saving in a 529 plan is no different than using a Traditional or Roth IRA or a regular savings account.
Reality: A 529 plan is the only account that gives you tax-free earning potential for educational expenses. The account is tax-deferred, meaning you don’t pay any taxes while invested, and any earnings are tax-free when used for qualified education expenses. In comparison, there are no tax advantages to investing in a savings account and, for the most part, if you use an IRA for college expenses, your earnings would be taxed, and in some scenarios, a penalty would be applied. All other things being equal, the 529 account generally gives you more money to use toward college rather than taxes.
Additionally, many states offer tax benefits for contributions to a 529 plan. That’s just another added bonus.
529 plans offer significant flexibility and tax benefits to help save for your child’s college education. If you’d like to know how much you should be saving for college, you can check out our College Savings Planner, but the most important thing is to save something, and to start saving earlier rather than later.
To learn more about the 529 plans that T. Rowe Price manages, visit troweprice.com/college.