3 Things You Must Remember About a 529 Savings Plan

By Markets Fool.com

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A 529 savings plan can be an excellent way to set aside money for your child's college education. However, there's a lot about these investment plans that isn't well understood by many Americans. We asked three of our contributors to discuss some things about 529 plans that you may not be aware of, and this is what they had to say.

What happens if your child doesn't need the money?

Matt Frankel: One of the most common questions I get from friends and family when explaining 529 plans is, "It sounds great, but what if my child doesn't go to college, or doesn't need all of the money in the account?"

In this situation, there are two main options. First, you have the ability to cash out the unused amount. You won't be penalized for taking out your original contributions, but could face a 10% withdrawal penalty on your investment earnings unless one of these criteria are met:

  • The beneficiary dies or becomes disabled.
  • The student attends a U.S. Military Academy.
  • The student receives a scholarship.

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In any case, the earnings portion of the withdrawn funds will be subject to income tax if you cash out. For example, if you've deposited $20,000 into a 529 and it is now worth $50,000, you can be assessed a penalty on up to $30,000 in non-qualified withdrawals. And if the money isn't used for education expenses, $30,000 is also subject to income tax.

The alternative to cashing out is to transfer the account to a different beneficiary, such as another child, or a niece/nephew. There are absolutely no penalties or tax consequences for changing an account's beneficiary, or rolling it into another 529 account. If you have more than one child, or another relative whose education you'd like to help pay for, this is the best option from a financial perspective.

There are two kinds of 529s: Prepaid or Savings

Selena Maranjian: A key thing to know about 529 plans is there are two key types: prepaid plans and savings plans.

With a prepaid 529 plan, you get to save and accumulate credits toward college tuition (usually at a public, in-state school), essentially lockingin current prices and protecting yourself from the rising cost of college. The savings version of the 529 plan lets you save and invest money (typically in stock and/or bond mutual funds) that can ultimately be used to pay for qualifying educational expenses such as tuition, books, room, board, and fees.

The prepaid model can sound pretty compelling, as college costs have grown at an average annual rate of 8% in recent years. There are downsides along with the upsides, though. For example, it often applies just to tuition, though someplans will also cover room and board. The prepaid 529 plan will also usually limit you to in-state public colleges, while savings plans can be used at a much wider range of schools, such as out-of-state ones and private ones -- and even some trade schools and foreign universities. The prepaid plan can present problems if you move out of state, too, as the credits may no longer cover all tuition.

If you're thinking that the savings plan is the way to go, know that it, too, has some downsides. A key one is this: Whereas the prepaid plan has you buying credits toward tuition, money in a savings plan is at the mercy of the underlying investments. Whether the market swoons or surges during your investment time frame will determine how helpful the 529 plan is for you. Learn more about your 529 plan options and their pros and cons before choosing one so that you go with the kind that's likely to serve you best.

Spend your 529 money wisely

Dan Caplinger: One thing to keep in mind with 529 plans is that there are things that you can and can't spend plan money on in order to qualify for tax-free treatment of withdrawals. In general, in order to get the tax benefits of 529 plans, you need to use the money for qualified educational expenses.

However, what counts as an educational expense has gotten somewhat broader in recent years. Tuition and required fees for college have always been the most important educational expenses covered by 529 plans. But you can also use 529 money for textbooks that are required for coursework, computers and related equipment used while enrolled in higher education, and even room and board expenses up to certain levels. When it comes to room and board, the costs must be less than either the amount stated in the school's cost of attendance figures for federal financial aid purposes or the actual amount that the educational institution charges the student for housing.

If you make a mistake and use money for a nonqualified purpose, you'll end up paying a 10% penalty on the portion of the distribution representing earnings on your initial investment. Scholarship recipients can get a waiver of the penalty, but taxes will still be due on the earnings. The best course is to make sure that withdrawals match up with expenses.

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