Debunking the Most Common 529 Plan Myths

A 529 plan is a tax-advantaged savings account sponsored by states or educational institutions to help families save for future education costs. Contributions are invested in various options, allowing the balance to grow based on market performance. The account owner can set aside funds for a designated beneficiary to cover a wide array of educational pursuits.

The Money is Lost if Not Used for College

The funds in a 529 plan are never permanently lost if the designated beneficiary chooses not to attend college. The account owner maintains control over the money and has several options if the original education plan does not come to fruition.

One of the most flexible options is to change the beneficiary. The account owner can designate a new beneficiary without incurring taxes or penalties, provided the new beneficiary is an eligible family member of the old one. This includes a wide range of relatives such as the beneficiary’s spouse, child, sibling, parent, or first cousin, allowing the funds to be repurposed for another family member’s education.

Should there be no other family member to designate, the account owner can make a non-qualified withdrawal. Original contributions are returned tax-free, but the earnings portion is subject to ordinary income tax and a 10% federal penalty. For example, if an account holds $20,000 in contributions and $5,000 in earnings, the $20,000 is returned without issue, while the $5,000 is taxed and incurs a $500 penalty.

The 10% federal penalty on earnings is waived under certain circumstances, although income tax on the earnings still applies. A primary exception is when the beneficiary receives a scholarship; an amount equal to the scholarship award can be withdrawn without penalty. Other exceptions include the death or permanent disability of the beneficiary, or their attendance at a U.S. military academy.

You Must Use Your Home State’s Plan

You are not restricted to your home state’s 529 plan and have the freedom to enroll in nearly any state’s plan. This flexibility allows you to shop for a plan that best fits your financial goals and investment preferences.

The primary incentive for using an in-state plan is a state-level tax benefit. Many states offer a full or partial income tax deduction or credit for contributions made to their own 529 plan. However, not all states offer such a tax incentive.

For residents of states with no state income tax or those that do not provide a deduction for 529 contributions, there is no tax-based reason to limit their choices. In these situations, it is advantageous to compare plans from across the country, focusing on factors like investment performance, management fees, and the variety of investment options available.

529 Plans Are Only for University Tuition

The use of 529 plan funds extends far beyond tuition at a traditional four-year university. The definition of qualified education expenses is broad, encompassing a wide range of costs at many different types of educational institutions. This flexibility ensures the funds can support various educational paths the beneficiary might choose.

Eligible Institutions

Funds can be used at any U.S. educational institution that is eligible to participate in federal student aid programs. This includes not only four-year colleges and universities but also community colleges, trade and vocational schools, and graduate schools. Eligibility also includes registered and certified apprenticeship programs, covering fees, books, supplies, and equipment for these programs.

Qualified Expenses

Qualified expenses include more than just tuition and mandatory fees. The money can pay for:

• Books, supplies, and equipment required for enrollment or attendance.
• Technology costs such as computers, peripheral equipment, software, and internet access.
• Room and board costs for students enrolled at least half-time, up to the amount specified in the school’s cost of attendance allowance.

Expanded Uses

Account owners can withdraw up to $10,000 per year, per beneficiary, to pay for tuition at an eligible K-12 public, private, or religious school. A lifetime maximum of $10,000 can also be used to repay qualified student loans for the beneficiary or their siblings.

Rollovers from a 529 plan to a Roth IRA for the beneficiary are also permitted. This is subject to several conditions: the 529 account must have been open for at least 15 years, and the funds being rolled over must have been in the account for more than five years. The rollover is subject to the beneficiary’s annual Roth IRA contribution limit and has a lifetime maximum of $35,000.

A 529 Plan Will Hurt Financial Aid Eligibility

While 529 plan assets are considered in financial aid calculations, their impact is often less significant than commonly believed. The ownership of the account is a determining factor in how it is assessed.

Parent-Owned 529 Plans

When a 529 plan is owned by a dependent student or their parent, it is reported as a parental asset on the Free Application for Federal Student Aid (FAFSA). Under federal financial aid formulas, parental assets are assessed at a maximum rate of 5.64%. For every $10,000 in a 529 plan, a student’s expected family contribution might increase by no more than $564, which is more favorable than assets held in the student’s name that are assessed at 20%.

Grandparent-Owned 529 Plans

Under current FAFSA rules, distributions from a 529 plan owned by a grandparent or another third party are not reported on the FAFSA. This means these funds do not impact the student’s federal aid calculation. This provides a benefit for families receiving help from relatives.

There Are Income Limits for Contributing

Anyone can contribute to a 529 plan regardless of their income level, as there are no income restrictions for contributors.

The limitations on 529 plan contributions relate to federal gift tax rules. For 2025, an individual can give up to $19,000 to any other single individual without incurring gift tax. This is known as the annual gift tax exclusion, and a married couple can combine their exclusions to give up to $38,000 to a single beneficiary.

A feature of 529 plans allows for a strategy known as “superfunding.” This rule permits an individual to make a lump-sum contribution of up to five years’ worth of the annual exclusion at one time. For 2025, this means an individual can contribute up to $95,000 per beneficiary in a single year without triggering the gift tax. To do this, the contributor must file a gift tax return to make the five-year election but will owe no tax if they make no other gifts to that beneficiary during the five-year period.