Avoid Falling for These 5 College Savings Myths

Reyna Gobel

Susan Bruno, a Connecticut parent with children now 20 and 24, would get excited when the value of the investments in college savings accounts dropped.

It meant that Bruno, a certified public accountant, could buy mutual funds in the tax-advantaged college savings accounts, known as 529 plans, at a discount, because the stock market as a whole had dipped in value. She knew the investments she bought were at a good price - on sale, effectively - and would increase in value when the economy rebounded.

She kept the investments for more than five years to give them time to grow, and the mutual funds that had dropped in price did eventually increase in value.

Expecting that a dip in the stock market will always hurt long-term college savings is just one of the myths parents have about college savings plans. Here are five more to avoid.

[Don't make these common 529 plan mistakes.]

Myth 1: I can only purchase a plan from my own state. Bruno's clients have said to her, "I have to go with the Connecticut plan, but oh, I want Vanguard." Clients who prefer plans with investments managed by Vanguard, for example, could purchase one of the 529 plans from the state next door, New York.

Parents can choose among 529 plans from all 50 states, she says.

However, a parent's home state may only offer tax deductions and credits for money invested in its own plan, Bruno says. Always look for the tax information on your state's 529 website before choosing another plan. Parents can also contact their state treasurer's office.

If your state doesn't have a state income tax, you should look for a plan based on your preferences: safest investment choices, lowest plan price or highest growth potential, says Ted Sarenski, a New York-based certified public accountant.

Myth 2: Performance is the most important aspect of my college investments. "It's not what you make, it's what you keep," says Bruno. "You still pay plan management fees even when your investments lose value."

Review 529 plans to understand what fees are charged, as well what the charges are for individual investments within a plan, she says.

The 2013 Morningstar 529 College-Savings Plans Industry Survey shows the average charges for advisor-sold plans with more investment choices is more than 1 percent, while direct-sold plans may be quite a bit cheaper. South Carolina's plan price is less than 0.2 percent annually.

Myth 3: I'll have to pay a tax penalty on all the money in the 529 plan account if it's not used for education. "The myth comes from how 401(k)s work," says Craig Steinhoff, a certified public accountant. For 401(k) retirement accounts, investors are taxed on preretirement withdrawals not made for an allowed exception such as a first-time home purchase.

With 529 plans, the account owner, normally the parent, is only taxed - and penalized - on what the 529 plan has earned. If the money is withdrawn because it was no longer needed - in the case of a scholarship award, for example - the 10 percent tax penalty is waived. But income tax is still charged on the earnings, just like it is for investments outside of 529s.

Myth 4: I'd be better off stashing the money elsewhere. There are rules to 529 plans that individuals who have invested in the stock market for a long time tend not to like.

Plan participants have limited choices for where to put their money, and can only buy and sell those investments once per year. Account owners also can't deduct losses on their taxes if the value of their mutual funds decreases.

[Take these steps before opening a 529 plan.]

However, "If parents save outside of 529 plans, they're missing out on a variety of benefits," Steinhoff says.

For instance, they won't qualify for tax-free growth of investments used for qualified education expenses, he says. Plus, there are a variety of investment options available within 529 plans, satisfying parents who like more control over investment choice.

As far as deducting losses, Bruno says, parents should ask themselves if they would rather have the ability to deduct losses or the ability to avoid taxes on plan growth. Since 529 plans historically have earned money, most of Bruno's and Steinhoff's clients prefer the latter.

Myth 5: I should stash every bit of college savings in a 529 plan. Parents shouldn't put every dime they think their children will need for college in a 529 plan, says Sarenski. A student could drop out after two years, or may earn a scholarship.

Parents should put some money for college in other investments for flexibility of use, he says. Plus, they can use the money for college expenses, such as transportation, that can't be withdrawn from a 529 plan without incurring a tax penalty.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.