8 Common Misconceptions About 529 Plans

As far as investments go, a 529 college savings plan is not particularly complicated. It's simply a vehicle that allows families to save for college costs with tax-deferred earnings growth and tax-free distributions. In addition, many states offer a tax break for residents contributing to their plans.

However, the rules about purchasing a plan and using the money can be challenging to understand, and there are numerous points of confusion about how 529 plans work. Here are some of the most common misconceptions:

1. You are limited to your home state's plan. Because states administer the 529 plans, many parents and grandparents mistakenly believe they are limited to those offered by their state of residence. In fact, a buyer can select any state's plan, but it's best to first see whether your state offers any tax benefit or expense reduction for residents.

James Dowd, managing director at North Capital, a San Francisco-based advisory firm, says confusion about a home state requirement is common. "Most of our clients are in California, and California doesn't offer that deduction, yet most people invest in the California state plan," Dowd says. "Quite frankly, it's not one of the better plans that's out there, so we often find there's an opportunity to get a better option for clients in getting them out of the state plan where they're invested."

2. Your yearly contribution limits are the same as in your individual retirement account. Total 529 plan contribution limits are set by the states and can be as high as $380,000. However, to avoid gift tax consequences, federal law allows single taxpayers to contribute up to $14,000 in one year or make a lump-sum contribution of $70,000 to cover five years. Married couples may contribute as much as $28,000 per year or $140,000 as a lump sum.

"It's not limited to $5,500 if you're under 50 like it is with an IRA," says Lindsey James, managing partner at Houston's LJK Financial. "We talk about this a lot with our higher-net-worth clients. It can be something really beneficial for grandparents. The husband and wife, together, can put in $28,000 for one grandchild, $28,000 for another, so it can be a way to get some money out of your estate."

3. Your income is too high to contribute to a 529 plan. In this case, some investors confuse a 529 plan with a Coverdell Education Savings Account, which is available to people with income below $110,000 for singles or $220,000 for those married filing jointly. "A lot of times, we'll get clients who say they're not eligible because they make too much money," Dowd says. Because 529 plans have no income limits for owners, even high earners can contribute and receive available tax breaks.

4. The account must be held in your child's name. "Usually it's best to have the account with the parent listed as the owner or the trustee with the child as beneficiary. People get confused about that quite often. They're not sure about the difference," says David McPherson, founder of Four Ponds Financial Planning LLC, based in Falmouth, Massachusetts.

With a 529 plan, the donor, not the beneficiary, is in charge. That means a child who's a beneficiary doesn't call the shots when he or she becomes of legal age (usually age 18) and would like to spend the money on something other than college. Once clients understand the donor is in control, that feature "tends to be something people like," James says. "That's unique, as opposed to a custodial account."

5. You'll lose the money if your child doesn't go to college or gets a scholarship. If, for whatever reason, a beneficiary doesn't use the money in the 529 plan, the assets can be transferred to another beneficiary. That often means another child in the same family receives the funds, but the beneficiary can also be another relative, such as a niece or nephew. A donor planning to go back to school can even change the beneficiary to himself or herself.

"A 529 plan is very flexible, but people don't seem to realize that," McPherson says. "I always emphasize the ability to move it around between different family members."

6. The money can only be used at a four-year college or university. Funds from a 529 plan can be applied toward many postsecondary education programs, not just traditional colleges. "Even if the child doesn't end up going to college, they may end up going to trade school or some sort of professional program where the funds can be used," Dowd says.

7. A 529 plan beneficiary must be below a certain age. This is another instance where people may be confusing a 529 plan with a Coverdell, which requires the account to be established before the beneficiary turns 18 and the balance to be spent by age 30. A 529 plan, however, can be opened for a beneficiary of any age, and the funds can be distributed regardless of how old the beneficiary is when he or she attends college or graduate school.

Even if a child is approaching college age, it's often worth opening a 529 account, Dowd says. "There's a benefit to almost anybody, as long as there are a few years left until your child is in college or until they complete college," he says.

8. It's not worth investing in a 529 plan because it will hurt your child's chance of getting financial aid. The rules about financial aid can be complicated, and they differ by state and by college. While 529 plans, in some cases, do factor into the financial aid calculation, McPherson says the benefits usually outweigh the drawbacks.

"I say put the money in the 529, because you're going to need it one way or the other. Even if you qualify for financial aid, it's pretty tight, so what you may be awarded is probably still going to leave you far short of what you need for college," he says.