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Demystifying the 529 college savings plan

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Although 529 college savings plans have been around for many years and continue to gain in popularity, there are still many common misconceptions about them. In fact, on average, 4 out of every 5 families will create savings plans to help pay for their children's college education. And yet there's a lot of confusion as to the best way to save for this huge expense. These tax-advantaged college savings plans fuel some common misconceptions.

Experts can explain how 529 college savings and prepaid plans offer significant tax savings and financial aid benefits. However, many families are still unaware or confused about how these plans can actually work to their benefit.

Needless to say, these tax-advantaged college savings plans fuel some common misconceptions. So we'd like to set the record straight by demystifying some of these popular myths.

By Jim Pavia, senior editor at large
Posted 21 November 2015

Four-year plan?

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Myth No. 1: They're only for four-year college students.

Not true! Both 529 prepaid and college savings plan funds are not just for a four-year private or four-year public college. You can also use the funds at community colleges and technical schools. However, attending unaccredited schools or certain foreign institutions (with some exceptions) won't count. In those cases, families will have the option to either roll over their 529 cash to another beneficiary or withdraw their funds and pay back taxes, as well as a 10 percent penalty on plan earnings.

State of mind

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Myth No. 2: You have to contribute to a 529 plan in your home state.

This statement is flat-out false. Any U.S. resident can contribute to a 529 college savings plan in any state. Contributing to a plan offered by your home state might offer an added bonus in the form of a state income-tax deduction, but that shouldn't be your sole consideration. If your state's plan is poor (with high fees and poor investment options, for example), looking at plans outside your state might be worth forgoing the tax break.

Here, there and everywhere

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Myth No. 3: You have to send your child to a school in the state where his 529 plan is offered.

False. A 529 college savings plan is fully portable, meaning that assets can be used for college expenses in any state and at some institutions abroad, regardless of which state's plan holds the account. This includes four-year public and private colleges, community college, trade schools and even some international schools.

Deduction dilemma

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Myth No. 4: You can only get a tax deduction if you contribute to your state's plan.

Usually true, but not always. The 529 plan policies vary from state to state, but for the most part, they follow the same basic guidelines. When surveying 529 plans, however, compare tax deductions, fees and expenses to find out if your state plans are fairly priced. In fact, residents of Arizona, Kansas, Maine, Missouri and Pennsylvania get a state income-tax break on 529 contributions made to any state's plan. Elsewhere, the benefit is restricted to contributions to in-state plans, with deduction limits varying from state to state and some states offering tax credits.

Use it or lose it?

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Myth No. 5: If your child doesn't go to college, you'll lose the money.

Wrong! Actually, unused 529 money does not have to go to waste — or to the tax collector. It can be used to help pay another family member's college costs, simply by changing beneficiaries or transferring funds to the family member's existing 529 account. And the list of potential recipients is rather long, including siblings, first cousins, parents, grandchildren, aunts and uncles, and even in-laws. If you do decide to cash out the plan, you'll have to pay federal and state income taxes on earnings, plus a 10 percent penalty (waived if the beneficiary dies, becomes disabled or gets a scholarship).