529 vs. Prepaid Tuition Plan: What’s the Difference?

States sponsor specialized, tax-advantaged accounts to help families prepare for the cost of higher education. The two most prominent options are the 529 savings plan and the prepaid tuition plan, each with a different framework for growing and using the funds.

Investment Structure and Growth Potential

A 529 savings plan is an investment account where contributions are placed into market-based portfolios of mutual funds or exchange-traded funds (ETFs). The plan’s value is tied to the performance of these investments, meaning the balance will fluctuate with the market. This structure introduces market risk but also offers the potential for substantial growth, similar to a 401(k) or IRA.

These investments can be handled in two ways. In a direct-sold plan, the account owner manages the investment selections. In an advisor-sold plan, a financial professional manages the investments for a fee, allowing for a more hands-off approach.

A prepaid tuition plan is a contract to lock in future tuition costs at today’s prices. Contributions purchase tuition credits or units for eligible colleges. The growth is linked to tuition inflation at participating schools, not the stock market. This approach removes market risk and guarantees what the funds will cover, but it also limits growth potential to the rise in tuition costs.

Use of Funds and Educational Institution Options

A 529 savings plan allows withdrawals for a broad array of qualified expenses at any accredited U.S. college, university, or trade school, and some international institutions. Qualified higher education expenses include:

• Tuition
• Mandatory fees
• Room and board
• Books
• Supplies

The definition also includes up to $10,000 per year for K-12 tuition and a lifetime limit of $10,000 to repay qualified student loans.

The funds are not tied to a specific state’s university system or a limited network of schools. This makes the 529 savings plan a portable option that can adapt to a student’s changing academic or geographic preferences.

Prepaid tuition plans are more restrictive. Their purpose is to cover undergraduate tuition and mandatory fees, often excluding costs like room, board, and books. The benefits are maximized when the beneficiary attends a participating in-state, public college. Using the funds for an out-of-state or private institution is possible, but the plan may provide a reduced value or a less favorable conversion rate.

Federal and State Tax Implications

Both 529 savings plans and prepaid tuition plans share federal tax advantages. Contributions grow on a tax-deferred basis, and withdrawals for qualified expenses are free from federal income tax. This tax-free growth and withdrawal is a primary benefit of these plans.

State tax treatment is where the plans can differ. Many states offer residents an income tax deduction or credit for contributions to their own state’s 529 savings plan, providing an immediate tax benefit. The availability and amount of these deductions vary by state, and similar incentives may be offered for prepaid tuition plans.

If funds are withdrawn for non-qualified expenses, the earnings portion is taxed as ordinary income and is subject to a 10% federal tax penalty. The earnings may also be subject to state income tax. Exceptions to the penalty include the beneficiary’s death, disability, or receipt of a scholarship.

Beneficiaries can also roll over unused 529 funds to a Roth IRA without tax or penalty. This is allowed if the 529 account has been open for at least 15 years. The rollover is subject to annual Roth IRA contribution limits and a lifetime maximum of $35,000.

Account Contribution and Ownership Details

For 529 savings plans, contribution limits are very high, often exceeding $500,000 per beneficiary, depending on the state’s plan. Anyone can contribute to a 529 account for a beneficiary. The account owner retains full control over the funds, including investment decisions and withdrawals, and can change the beneficiary to another qualifying family member without tax consequences.

Prepaid tuition plans structure contributions around the purchase of specific tuition credits or semesters. Contribution limits are based on the cost of tuition at participating schools. Ownership rules can be more rigid, and options for changing the beneficiary may be more limited than with a 529 savings plan.

On the Free Application for Federal Student Aid (FAFSA), both plan types owned by a parent are reported as a parental asset and assessed at a low rate in the aid calculation. Qualified withdrawals from an account owned by a grandparent or someone other than the student’s parent are no longer counted as student income, preserving the student’s eligibility for financial aid.