A 529 college-savings account can be a great way to save for your child’s or grandchild’s college costs while getting big tax breaks. But with these accounts, it’s easy to make a mistake that would reduce your savings…force you to pay tax and even a penalty…or cause you to miss out on financial aid. Here are today’s common 529 account mistakes and how to avoid them…

Mistake: You assume that your state’s 529 plan is your only option. Nearly every state sponsors its own 529 plan, which allows you to permanently avoid income tax and capital gains tax on any investment profits when you use the money for qualified college costs. But you are allowed to invest in a different state’s 529 if you prefer—and sometimes that is the best option.

If you live in a state that offers a significant state income tax break on contributions to its 529 plan, it’s probably best to stick with that state’s plan. But there’s no reason to do so if you have reached the limit for a tax break in a particular year or if it is a state that…

  • Doesn’t provide an income tax break, such as California, Delaware, Hawaii, Kentucky, Maine, New Jersey and North Carolina.
  • Has no state income tax, such as Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.
  • Offers the same tax break whether you choose its plan or a different state’s plan, such as Arizona, Kansas, Missouri, Montana and Pennsylvania.

Exception: An uncommon type of 529 plan known as a “prepaid plan” generally is open to only in-state residents. Most savers do not opt for prepaid plans even when they are available, however, because they tend to be very restrictive, using financial incentives to steer students to enroll in specific state university systems. Conventional 529 plans are far more flexible—money saved in them can be used at essentially any US college plus many foreign ­colleges.

If you shop out-of-state for a 529 plan, lean toward plans that offer low-expense investment options with strong track records. Among the best state plans are those in California (ScholarShare.com), Iowa (CollegeSavingsIowa.com), Maine (­MerrillEdge.com/offers/529), Michigan (MISaves.com), Nebraska (Nest529Direct.com), Nevada (Investor.Vanguard.com), New York (NYSaves.org), Utah (UESP.org) and Wisconsin (Edvest.com). For ratings and descriptions of 529 plans, visit SavingForCollege.com.

It’s not too late to make a change if you already have invested in your own state’s 529 plan and then realize that there might have been a better option. You can make one 529 rollover per beneficiary in any 12-month period without generating any taxes or penalties.

Mistake: You are not the student’s parent, and you withdraw money for college payments from your 529 account early in the student’s college career. This can unintentionally undercut the student’s financial aid. When a student’s grandparent (or uncle or anyone else other than a parent) withdraws money from a 529 account, the college financial-aid system treats the money as untaxed income for the student even if it is appropriately used to pay college costs—and the more income the student has, the less financial aid he/she is likely to ­receive.

To get around this, if the parents are able to cover expenses for the first two years, nonparents can wait to withdraw money from their 529 accounts until the student’s final two calendar years of college. A student’s financial aid in any given year is calculated using the family’s “prior prior” tax return—2015’s return affects 2017’s financial aid, for example. So if the nonparent waits until the final two calendar years that the student is in college, the income from this 529 should not affect the student’s aid at all.

Another option for grandparents and other nonparents is to put money into a 529 account owned by the student’s parents. The financial-aid system will consider this money parental assets, which has a smaller impact on financial aid than does student income. Note: Contributing this way could cost the nonparent a state tax break on 529 contributions…and it means that the nonparent loses legal control over the assets after they are contributed. A small number of plans do not accept “third-party” contributions, so a nonparent would have to give the money to a parent and have the parent make the contribution.

Mistake: As a parent or other person claiming a student as a dependent, you take excessive advantage of a 529 plan while getting education-related tax credits at the same time. If you claim an education-related tax credit such as the Lifetime Learning or American Opportunity credit, tax law requires that you subtract the education costs covered by that credit from your qualifying education expenses when you ­determine how much to withdraw from your 529 account that year. Fail to do this properly, and you could end up owing income tax and a 10% penalty on a portion of your 529 withdrawal. It’s easy to go wrong here because, counterintuitively, the amount you need to subtract from your 529 withdrawal can be greater than the amount you receive from the tax credit. Example: If the credit is 20% of the qualifying educational expenses up to $2,000, you would need to subtract the full $2,000 used to “support” the credit, not just the $400 credit you receive.

Mistake: You withdraw money from a 529 account for expenses that will not be paid until the following calendar year. Do not withdraw money in December to pay for spring-term tuition unless you are certain that this money will be paid to the college before the end of December. If the qualifying college expenses that you pay during a calendar year are less than the amount withdrawn from your 529 account during that year, the IRS likely will insist that you pay tax and a penalty—even if the excess is used to pay qualifying expenses in the first few days of the following year.

Mistake: Withdrawing money from a 529 to cover the cost of the student’s travel to or from campus. Money can be withdrawn from 529 accounts for a range of college-related expenses including tuition, fees, room and board, books, computers, computer-related equipment and Internet access—but not travel costs.

Mistake: You assume that you can’t withdraw money to cover the student’s housing and food costs if the student lives and dines off campus. Off-campus housing and food costs are qualifying expenses up to the amount that the college charges for on-campus room and board as long as the student is enrolled in school half time or more.

MISSING-BENEFICIARY MISTAKE

Here is one of the worst mistakes you could make in a 529 plan…

You pay tax and a penalty to liquidate all or part of a 529 plan because the beneficiary doesn’t go to college…the beneficiary drops out of college…or the college ends up costing less than you saved in the 529. Liquidating a 529 is not the only option, and often not the best option, when the 529 can’t be used for college. You could instead use 529 savings to send the beneficiary to a trade school—many of these are eligible under 529 rules. If you have money left in your 529, you also could change the beneficiary to another member of your current beneficiary’s extended family without penalty. (See SavingForCollege.com for details on what constitutes eligible “family.”) Or you could name yourself as beneficiary and use the money to go back to school yourself—everything from grad schools to local community college classes to culinary schools could be eligible. (For a list of eligible institutions, select “Is Your Institution 529 Eligible?” under the “Tools & Calculators” menu at SavingForCollege.com.)

Some good news: If you do pull money out of your 529 account for nonqualifying expenses, only the portion of the withdrawal stemming from investment gains within the 529 will face income tax and that 10% penalty. The money you originally deposited in the account will not.

Helpful: If your 529 beneficiary earns tax-free scholarships, you have the option of removing from the account an amount up to the amount of those scholarships and using the money for nonqualifying expenses without paying the usual 10% penalty, though you would have to pay income tax on the earnings. (Similar rules apply if the beneficiary attends a US military academy that does not charge tuition.)