Remember the days before the internet? It was almost impossible to access certain information, like song lyrics. People would go years singing the wrong words while insisting they were right.

For instance, I thought Johnny Nash was singing “I can see clearly now, Lorraine is gone.” My husband set me straight that it was “I can see clearly now, the rain is gone.” I suppose that makes more sense.

Now you can type a few words into your phone, and Google will tell you the lyrics to any song. It’s that simple. Unfortunately, getting answers to financial questions isn’t always that easy, even with the vast resources available online.

Take 529 savings plans. They’re a popular college savings vehicle, but many people misunderstand how they work or can’t find answers to their 529 questions.

To help clear things up, here are answers to 5 of the most common questions I’ve received about this topic.

Can my child use a 529 plan from a different state?

The fact that states offer their own 529 plans confuses many investors. You might think you have to invest in your own state’s plan, but that’s not true. While there are often advantages to investing in-state, you can choose to invest in a 529 plan from any state. This gives you the opportunity to shop around and pick one that meets your criteria—a low minimum investment, low fees, and a variety of investment options, for example.

So how do you choose the right plan for you? Here’s an easy 3-step process to get started:

  1. Find out what tax breaks your state offers. More than 30 states, plus Washington, D.C., offer full or partial state tax deductions for 529 plan contributions. However, only 7 of those states offer the deduction regardless of which state’s 529 plan you invest in. To find out how much you might save, use our 529 plan state tax deduction calculator.
  2. Take into account the plan’s fees and costs. The expenses associated with 529 plans vary significantly. For instance, some plans are advisor-based and, therefore, require you to pay commissions on your investments. In general, direct-sold plans cost less. To compare costs, look up different state plans on this interactive map.
  3. Consider the investment options available. Once you select a plan, you’ll then need to choose investments. If you’re looking for an easy way to manage your investments, look for a plan that offers age-based options. Similar to target-date retirement funds, age-based options automatically adjust your asset allocation over time. So as your child gets closer to college age, your investments will shift to more conservative portfolios—giving you one less thing to worry about.

What impact do 529s have on financial aid?

Because you have to declare 529 assets on financial aid forms, parents often worry that saving in a 529 will prevent their child from qualifying for grants and income-based scholarships. Some even try to sidestep this issue by opening the plan in the name of someone outside of the immediate family (like a grandparent).

How it actually works

The effect of a 529 plan on financial aid is minimal. And opening an account in a grandparent’s name is likely to backfire—making the child less likely to receive aid.

The reason? High income has a much more negative effect than assets when qualifying for financial aid. If the 529 plan is parent-owned, it’s considered an asset. If the 529 plan is in someone else’s name, the withdrawals are considered income.

Here’s how it works on the Free Application for Federal Student Aid (FAFSA): Assets (including 529 plans) held by a parent can reduce need-based aid by 5.64% of the asset’s value. That means if you have $10,000 in a 529 plan, that savings could reduce aid by $564.

However, student income can reduce the amount of aid by much more. In the case of a 529 plan held by a grandparent, the money used to pay for tuition must be reported as untaxed income for the student on the following year’s financial aid forms. And it could reduce the amount of aid by 50%.

Let’s say a grandparent owns the 529 plan and withdraws $10,000 to pay for tuition. The next year, that withdrawal could increase the amount the family is expected to pay by $5,000.

In the end, it may be better for generous grandparents to gift money to the parent-owned 529 plan.

This example demonstrates how complicated it can be to maximize aid. It’s true that financial aid can be a big help when paying for college. But trying to arrange your finances so your child will be more likely to qualify for grants or other aid is tricky business. And counting on aid leaves you at the mercy of college administrators. A better approach is to save early and as much as you can toward college costs.

What taxes and penalties will I pay if I withdraw 529 assets for nonqualified expenses?

Many people are concerned that their children won’t attend college or will need to use their 529 savings for expenses not related to education.

First, keep in mind that 529 plans provide a lot of flexibility. You can use the assets for tuition at a college, university, trade school, or vocational school. You can also use it for other higher-education expenses, such as room and board, fees, books, supplies, equipment, computer hardware and software, and internet access and related services.

Here’s more information on qualified & nonqualified expenses.

But what if your child ends up choosing a different path? You have a few options. You can transfer the account to another family member or even use it yourself. Or you can leave the money in the plan in case your child decides to attend school later (there’s no age limit).

It’s true that there are penalties for withdrawing the assets to pay expenses not related to education. However, these penalties only apply to the earnings portion of your withdrawals. They include:

  • Federal income tax.
  • A 10% federal penalty tax.
  • State and local taxes (if you claimed a deduction or credit).

Example: You have a 529 plan with $10,000 of contributions and $2,000 of earnings, for a total of $12,000. Let’s say you have to take it all as a nonqualified withdrawal—this, of course, would be a worst-case scenario. You’d only owe federal taxes and the penalty on the $2,000 in earnings. If you deducted your contributions from your state income taxes, you may also have to report state “recapture” income.

What are the benefits of saving in a 529 plan?

Here are the key advantages of a 529 plan:

  • Federal tax benefits. While contributions aren’t deductible from federal taxes, earnings in 529 plans grow tax-free and won’t be taxed when you take the money out to pay for college.*
  • State tax benefits. As I mentioned in the first question, more than 30 states offer a full or partial tax deduction for 529 plan contributions.
  • Control. The parent (or account owner) has control over the account. In most cases, the named beneficiary has no legal rights to the assets. As a result, parents can feel confident that the money will be used for education.
  • Simplicity. It’s an easy way to save for college. And most plans let you set up automatic investments, where you link your bank account to your 529 account. This allows you to add to your savings in a convenient and systematic way. You can also invite others to celebrate your child’s milestones with the gift of education savings. The gifts are then deposited directly into your 529 plan account.

What’s a reasonable college savings goal—100% of tuition? 50%?

Any amount that you save will make it easier for you and your child when it comes time to face college costs. Few of us can save 100%, so we recommend striving to save about 30% of the total price tag. However, even that number is difficult for many families to meet.

According to the most recent figures from Sallie Mae, most parents cover about 23% of costs with income and savings. The rest comes from student and parent loans, grants, scholarships, and gifts from relatives.

If you’d find it helpful to have a specific savings goal in mind, look up the cost of a particular college and choose a percentage to shoot for. Then, to help meet your goal, consider setting up automatic investments or ask relatives to contribute to the plan instead of giving your child gifts.

Remember, every dollar you save is a dollar you or your child won’t have to borrow in the future.

It’s worth the effort!

There are certain song lyrics that I will never decipher. And to me, it’s not worth the effort to look up the words.

But for anyone interested in saving for college—whether it’s for your child, your grandchild, or another close relative—529 savings plans are worth taking the time to understand.

*Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

For more information about any 529 savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program. Other state benefits may include financial aid, scholarship funds, and protection from creditors. Vanguard Marketing Corporation serves as distributor and underwriter for some 529 plans.

We recommend that you consult a tax or financial advisor about your individual situation.