Types of 529 Plans: Savings vs. Prepaid
Understand the key trade-offs between different 529 plans to select an education savings strategy that fits your financial comfort level.
A 529 plan is an account designed to help families set aside funds for future education costs. These plans provide a tax-advantaged method for savings, as contributions are allowed to grow tax-deferred. This means no federal income taxes are paid on the earnings as they accumulate. When the funds are withdrawn, they are free from federal income tax, provided they are used for qualified education expenses.
Education Savings Plans
An education savings plan operates like a personal investment account, where contributions are placed into market-based options such as mutual funds. The account owner directs how the contributions are invested by choosing from a menu of portfolios offered by the plan. The account’s value will fluctuate with market performance, which introduces both the potential for growth and the risk of loss.
These plans offer flexibility in how the funds can be used. Qualified expenses include college tuition, mandatory fees, room and board, books, supplies, and required equipment like computers. Funds can be used at any eligible college, university, or vocational school nationwide. The definition of qualified expenses also includes up to $10,000 per year for tuition at public, private, or religious K-12 schools.
The investment strategy can be tailored to the beneficiary’s age and the family’s risk tolerance. Many plans offer age-based portfolios, which automatically shift from aggressive to more conservative investments as the beneficiary nears college age. Alternatively, account holders can select static portfolios that maintain a fixed asset allocation.
Starting in 2024, unused funds from a 529 plan can be rolled over to the beneficiary’s Roth IRA without federal tax or penalties. This rollover is subject to several conditions.
- The 529 account must have been open for at least 15 years.
- The funds being moved must have been in the account for at least five years.
- There is a lifetime rollover limit of $35,000 per beneficiary.
- The annual rollover amount cannot exceed the yearly Roth IRA contribution limit.
- The beneficiary must have earned income at least equal to the amount being rolled over.
Prepaid Tuition Plans
A prepaid tuition plan allows an account owner to lock in future tuition costs at today’s prices. Participants purchase tuition credits that are guaranteed to cover a set amount of future tuition and mandatory fees at eligible institutions. The value of the purchased credits rises with tuition increases at participating schools, removing the uncertainty of tuition inflation.
These plans are sponsored by state governments for use at in-state public colleges and universities. They are designed to cover only the cost of tuition and fees, not other expenses like room and board or books. The guarantee provided by these plans is often backed by the sponsoring state.
A separate option, the Private College 529 Plan, allows participants to prepay tuition at a network of private colleges nationwide. It functions like state-sponsored prepaid plans by locking in current tuition rates. Both state and private prepaid plans may have residency requirements and specific enrollment periods.
Key Differences for Decision Making
The primary difference between the plans is investment control versus cost certainty. With an education savings plan, the account owner assumes market risk, as the account’s value is tied to investment performance. A prepaid tuition plan eliminates this risk by guaranteeing that purchased credits will cover future tuition, providing a predictable outcome.
Flexibility is another differentiator. Education savings plans can pay for a wide range of qualified expenses at nearly any accredited postsecondary institution. Prepaid plans are more restrictive, limiting funds to tuition and fees at a specific network of colleges. Using prepaid benefits at an out-of-state or non-participating school may result in receiving a lesser value.
State tax benefits can also influence the decision. Over 30 states offer an income tax deduction or credit for contributions, but a resident must use their home state’s 529 plan to qualify. The available state tax benefit could steer a resident toward one type of plan if their state offers both.
For financial aid, a 529 plan owned by a dependent student or their parent is reported as a parental asset on the FAFSA. This is favorable, as parental assets are assessed at a lower rate than student assets. A change to FAFSA rules also benefits families receiving help from others, like grandparents. Distributions from a 529 plan owned by a non-parent are no longer required to be reported on the FAFSA, which protects the student’s aid eligibility.
Opening a 529 Plan
Opening a 529 plan begins with selecting a specific plan. This can be done directly through a state-sponsored plan’s website or by working with a financial advisor. The choice depends on whether an individual prefers to manage the account independently or desires professional guidance.
To complete the application, you will need to provide personal information for both the account owner and the beneficiary. This includes:
- Full legal names
- Permanent addresses
- Dates of birth
- Social Security or Taxpayer Identification Numbers
After the application is submitted online or by mail, the final step is to make an initial contribution. Most plans have low minimum contribution requirements. Subsequent contributions can be made through methods like electronic bank transfers or payroll deductions.