Myths About 529 Plans

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. 529 education savings plans are popular tools for saving for college. Yet, despite that popularity, misunderstandings abound about them. Joining me today to provide some clarity on several 529 plan myths is Patty Oey. Patty is a senior analyst with Morningstar's manager research group.

Hi, Patty, nice to see you.

Patricia Oey: Good to see you, too.

Dziubinski: One myth about 529 plans is that they can only be used to cover college tuition. But that's really only part of the story. What else can 529 assets be used to pay for?

Oey: Yeah, so you're right. Definitely tuition and fees. It actually can also cover room and board. And should you decide to live off-campus, you can use 529 money to pay for those expenses, up to what the college charges for room and board. So you can do that as well. And then 529 money can also be used for books and your computer. And then the IRS has a list of what other qualified expenses are, but those are the big categories and the big expenses.

Dziubinski: Now, in some states also 529 plans can be used for some K through 12 expenses. Is that right?

Oey: Yes, that's correct. The federal government put that in one of their recent acts. And at the state level, not all states have agreed to this idea. And so what happens is that if you're in a state which does not allow that, what will happen is that when you take money out of your 529 and then use it to pay for K through 12 private-school tuition, it will not account as a qualified expense, and then you will be charged a penalty

Dziubinski: Got it. Now, another myth, perhaps, is that investors are better off sticking with their own-state-sponsored 529 plan because they're going to get some sort of tax benefit in doing so. But not all states offer a tax benefit. Right?

Oey: Right. Yes, about a handful of states don't offer any state tax benefit. And when we say "tax benefit," we mean state income tax. So like a deduction when you're calculating your state income tax liability. Some states don't offer it. Some states like Florida and Nevada, they don't have an income tax, so there's no benefit to offer. And then maybe about 30 states offer some kind of benefit, but it's important to consider what the benefit is. For one example: Rhode Island, the maximum deduction you can take is $1,000. If you just kind of back-of-the-envelope estimate, if you're a family, you make $100,000 a year, you file jointly, if you make $1,000 contribution to a 529 account or three, you can only deduct $1,000. And then given their tax rates, that's only a savings of like $50, which is not that significant. Other states have a higher limit on how much you can deduct. And maybe if the state taxes are also higher, that same family contributing $3,000, maybe that's worth a couple of hundred dollars per year.

Dziubinski: Even if your state does offer a tax deduction or a tax benefit, like you're talking about, there are reasons sometimes where you wouldn't even, nevertheless, you wouldn't stick with your state's plan.

Oey: Right. If the tax benefit is not attractive, but also you can look at the plan. If the investment options are fairly mediocre and, then again, if the fees are really high, definitely you can consider looking at other plans. At Morningstar, we do rate over 60 plans. Some of the summaries of our ratings are available on our website. And if you're a subscriber, you can also look at the individual reports on the individual plans.

Dziubinski: Another myth is that there are contribution limits to 529 plans, which maybe change annually the way contribution limits change to IRAs or 401(k)s, but that's not the case, right?

Oey: I mean, technically, when you contribute into a 529 account, it's considered a gift. So it's subject to the gift tax. And so the exclusion in 2022 is $16,000. And that is per beneficiary, per giver. So, I can give $16,000 to son number one, I can give $16,000 to son number two, and then if my husband wanted to, he can do the same, effectively doubling our gift. If you were to go over the exclusion, it just counts against your lifetime exclusion, which is $12 million.

Dziubinski: Patty, another myth that some people believe is that 529 plans will get in the way of how much financial aid a child will qualify for. Is that true?

Oey: Yes, this is a very popular question, and a lot of people are concerned about it. When you want to apply for financial aid, you have to fill out the FAFSA form. What the government does is that it evaluates how much the parents can contribute for your education. So they look at the parents' income—that is weighed most heavily in terms of how much the parents can afford to pay for school. They also look at savings; that's weighed a lot less, and in that savings bucket includes 529 but also includes bank accounts and other investment accounts. But the idea is that if you are going to be using savings to pay for the school, then it just makes a lot of sense to invest in a 529 account with the tax benefits. But overall, anything that you do to reduce the potential need for more debt in the future will benefit the child in the future.

Dziubinski: And then lastly, some might think, "OK, well, I want to set up a 529 plan, but I'm a little uncertain whether the beneficiary is going to pursue a college education, and then what happens to the money? Is it taxed? Is it gone? What happens?" And that's not really the case? What are some things that can be done with 529 assets if, in fact, that beneficiary decides not to pursue what people might think of as a traditional four-year college education?

Oey: Right? Yeah—money disappearing? Nobody wants to hear that. So yes, the child maybe gets a full scholarship or decides not to go to school, there are options. The tax code is pretty liberal. You can change the beneficiary. And typically, you can change it to another member of the family, and they are reasonably liberal, where you can change it to another child, but you can also change it to a niece or nephew, a cousin, and also spouses. The IRS has the list, but it's pretty broad in terms of who you can change it to. There's no tax liability for that change. Some might say that there's always the risk that the government will change the laws in the future, and then you know, that would be a problem. That's not on the table right now. It's not a concern at this moment.

Dziubinski: Great. Well, Patty, thank you so much for helping bust some of these 529 myths. We appreciate your time.

Oey: Thank you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.