I hear from people quite often, and I read articles and questions online even more often, about being worried to contribute to a college savings account, called a 529 plan, because of fears of saving too much for college. They heard from a friend of a cousin who watched a program about a penalty on withdrawals that aren't used for school. And let's be honest, nobody likes paying penalties!
This is not as scary as it seems.
How a 529 Works
This is a high-level look at a 529 college savings plan. For more information, check out SavingForCollege.com, this post about college savings, or an I wrote for Investopedia.
A 529 plan is a type of account that allows you to save for college in a tax-efficient way. It's one type of account, much like an Individual Retirement Account (IRA) or 401(k) for retirement, or Health Savings Account for health care costs. With a 529 you put your money in after paying tax - which means you do not get a tax deduction. This makes it very similar to a Roth IRA. The earnings in the account grow tax free, and you can take money out tax free as long as that money is used to pay for qualified education expenses.
As the parent, you own the account and assign your child as the beneficiary (although, you can be the beneficiary, too, or anyone else for that matter).
Here is where people tend to get scared. If you don't use the money in the 529 for qualified expenses then you have to pay taxes and a penalty!
Although that's true in some cases, it's not the whole story. Since there was no tax break on your deposits, that money is yours...period. There is no tax on the money you put in. There is no penalty on the money you put in. Any taxes or penalties are applied ONLY to the gains in the account (there are some state-specific laws here that may apply depending on your state and their treatment of 529s).
I'd like to share with you some of the scenarios in which you might not be able to use the money for education expenses and what's the worst that will happen.
If you save and save for college and your child gets a scholarship, many view this as bitter sweet. One one hand, you don't have to pay for college. On the other hand, you now have to pay those dreaded taxes and a penalty!