The main difference between a prepaid tuition plan and a 529 plan is that prepaid tuition plans allow you to secure tuition credits at today’s rates.
Prepaid tuition plans and 529 college savings plans are specialized savings accounts used to cover future college costs. Prepaid tuition plans work like defined benefit plans, while 529 plans work like defined contribution plans.
There are other significant similarities and differences between them. Get details on each to see which plan best fits your college needs.
What is a prepaid tuition plan?
Our prepaid tuition plan lets you purchase tomorrow’s tuition at today’s prices. It locks in the cost of college, so that a year of tuition always equals a year of schooling. Prepaid tuition plans provide peace of mind by locking in tuition rates.
The funds are invested by the plan administrator to attempt to provide a hedge against college tuition inflation. This works well when the stock market is booming and tuition increases are modest.
But during an economic downturn and for several years afterward, tuition rates rise at above-average rates and stock prices fall, putting pressure on the prepaid tuition plan from two directions.
Many prepaid tuition plans suffer from an actuarial deficiency, where the assets of the prepaid tuition plan are insufficient to cover expected future college costs.
Prepaid tuition plans by state
Some prepaid tuition plans are guaranteed by the full faith and credit of the state, but it is unclear what this really means in practice.
Prepaid tuition plans typically react to actuarial shortfalls by closing to new investment, terminating plans, and reducing the value of benefits. Prepaid tuition plans also charge a premium over current tuition rates to cover anticipated shortfalls.
The premiums have increased, so the financial benefits of prepaid tuition plan are not as good now as they were before. The refund value of the prepaid tuition plan is also limited.
Only eight of the nearly two dozen original prepaid tuition plans are still open to new participants, including eight government prepaid tuition plans and a private college 529 plan.
What is a 529 plan?
A 529 plan provides tax benefits and financial aid to help families invest money to pay for future educational expenses. Contributions to a 529 plan are made in after-tax dollars. Contributions are eligible for state income tax deductions or tax credits in two-thirds of states.
Earnings grow on a tax deferred basis. 529 plan distributions are tax deductible if used to pay qualified education expenses. 529 plans have no annual contribution limits, but contributions are subject to gift tax limitations.
A shareholder can waive the annual gift tax exclusion for each beneficiary without incurring gift taxes. 529 plans also offer a five-year gift tax average, sometimes called superfunding, which is treated as occurring reasonably over a five-year period. 529 plans have aggregate contribution limits that vary by state. Most 529 plans offer a menu of between one and twenty investment options, such as stock and bond mutual funds.
529 plan investment options
All 529 plans offer dynamic investment options, such as asset allocation based on age or enrollment date, as well as fixed investment options. There are two main types of 529 plans, direct selling and advisory selling. Direct-sold plans are state-administered and have lower fees than advisor-sold plans, which are managed by a financial advisor.
Minimizing costs is key to maximizing net returns. Most families should choose a 529 plan that charges less than 1%. There may be a trade-off between lower fees and state income tax breaks.
In general, families should choose a 529 plan that charges lower fees until the child reaches high school, when they should roll over the new investment into the state’s 529 plan if the state offers an income tax exemption on contributions.
Wyoming is the only state that does not offer a 529 plan. Most offer a direct-sale 529 plan and one or more 529 plans sold by advisors.
What are the differences between prepaid tuition and 529 plans?
Both prepaid tuition plans and 529 plans offer tax benefits and financial aid, as well as other flexibility. Distributions are tax-deductible if used to pay qualified education expenses.
The earnings portion of a nonqualified distribution is subject to income tax at the recipient’s rate, plus a 10% tax penalty, plus the possibility of clawback of state income tax credits.
If the dependent student has a prepaid tuition plan or 529 plan, they will be reported as an original on the FAFSA. This results in less impact on eligibility for need-based financial aid. The account holder has the option to change the beneficiary to a family member of the current beneficiary.
Unlike the Coverdell Education Savings Account, There are no income restrictions on contributions to prepaid tuition plans or 529 plans. Both prepaid tuition plans and 529 plans offer automatic investment options and families can save with both. However, there are major differences between the two.
In-state residency is a key factor, as prepaid tuition plans are limited to in-state residents, while most 529 plans are not. The Massachusetts Prepaid Tuition Plan and the private college 529 plan are the only exceptions.
Eligible colleges also vary. Prepaid tuition plans can only be used at public colleges in the state of purchase. If the student attends a private or out-of-state college, the family must pay the cost difference. However, prepaid tuition plans can be rolled over to a 529 plan.
Time and age limits also exist. Most prepaid tuition plans must be used within 10 years of regular college enrollment, with some states capping 8 years, 15 years, or 30 years. A private college 529 plan has a term of 30 years. Some prepaid tuition plans also have age limits, such as age 30 unless still in college, with extensions for military service. Prepaid tuition plans have a limited open enrollment period, while families can open a 529 plan at any time.
There are also differences in the definition of eligible expenses. Eligible expenses for the Prepaid Tuition Plan are limited to tuition and required fees.
Eligible expenses for a 529 plan include:
- teaching
- expenses
- books
- Supplies and equipment
- Cost of computer (including peripherals, software, and Internet access)
- Expenses for people with special needs
- Accommodation and food (if the student is enrolled at least half-time)
Additionally, 529 plans can be used to pay up to $20,000 annually in K-12 expenses and up to $10,000 (lifetime limit per borrower) in student loan repayment for the student and his or her siblings.
