A 529 savings plan can be a great way to save money for your child's college education, but many Americans don't fully understand this type of account. Here are three things to keep in mind when considering a 529 plan for your college savings strategy.

Source: Wikimedia Commons user Eduard STOICA.

Dan Caplinger
529 plans are extremely useful for college savings, but the quality of plans across the nation varies widely. Getting stuck with a bad plan can leave you worse off than you'd be if you had simply invested on your own outside a 529, even though a regular brokerage account doesn't offer the tax-deferred growth and tax-free withdrawals for educational expenses that 529 plans currently offer.

One thing to keep in mind, therefore, is that you don't have to use the 529 plan that corresponds to your state of residence. Most 529 plans are open to residents in all 50 states and offer the same investment options and fee schedules to residents and nonresidents alike.

There are some state plans that offer additional benefits to residents, though. One common provision is to offer state income tax credits or deductions for contributions, giving residents a state tax break that nonresidents won't be able to enjoy. Yet even when your state offers a tax incentive to stay close to home with your college savings, it's important to weigh those incentives against the costs that your plan imposes. Over an 18-year time horizon, costly fees can overwhelm tax advantages if your plan is bad enough.

Matt Frankel
One of the most common questions people have when considering a 529 plan for their children is "What if my child doesn't use all, or any, of the savings? Won't I get hit with a big tax bill for reclaiming the funds in the account?"

The short answer is yes, but many people don't realize that 529 plans are transferable, with no costs or penalties. Any unused funds in a 529 account may be rolled over to qualifying family members, which include pretty much any relative. You can choose to roll over the funds to the beneficiary's spouse, child, sibling, parent, grandparent, stepmother, stepfather, cousin, niece, nephew, or the spouse of any of those people.

So, while any earnings from 529 investments that are not spent on qualified education expenses are subject to income tax plus a 10% penalty, there's a better option. Whether or not your child goes to college, you can still use the money tax-fee for another loved one's education.

Dan Dzombak
When the time comes for your student to start making withdrawals from a 529 plan, it's important to know what counts as a qualified higher education expense. This is important because withdrawals from 529 plans are tax-free only for qualified higher-education expenses. If you use the withdrawals for non-qualified expenses, you have to pay taxes on the investment earnings at the ordinary income tax rate, as well as a 10% tax-penalty.

First, note that for the expenses to be qualified, the beneficiary must be enrolled at a qualified school at least half-time. A qualified school is generally any college, university, vocational school, or other post-secondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education.

So what does count as a qualified expense?

  • Tuition
  • Room and board costs, though these may not exceed the limits determined by the school for Federal financial aid purposes.
  • Fees required by the university
  • Supplies required by the university, such as calculators
  • Textbooks required by courses

What does NOT count:

  • Laptops and computer-related expenses. In 2009 and 2010, these were temporarily on the IRS' qualified expenses list due to the stimulus bill, but they do not currently count as qualified higher-education expenses. These can count as qualified if the university requires students to have laptops, but parents need to be able to prove that this is the case.
  • Insurance
  • Transportation expenses
  • Repayment of student loans
  • Costs that are not required, including any costs for activities, sororities and fraternities, intramural sports teams, clubs, etc.
  • Lifestyle expenses and furnishings

The other thing parents should note is that the same expenses cannot be used to qualify for other education-related tax benefits such as the American Opportunity Credit and the Lifetime Learning Credit. Basically, you can't double-count your expenses for the education benefits the government grants you.