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How To Save For College with 529 Plans

Named after the section of the tax code that governs them and legally known as "qualified tuition plans," 529 plans are tax-advantaged savings programs created to help families save money for college. There are different advantages, options, restrictions and fees in every state, so before buying a 529 plan request an official statement from the plan sponsor or a professional financial advisor, and do your homework! Most 529 plans provide official statements on their web sites, you can find official links here: The National Association of State Treasurers' College Savings Plans Network or you can call them toll-free at 877-277-6496 for information on the 529 plans you are interested in.

Two Types of 529 Plans

Two types of 529 plans

There are two types of 529 plans - prepaid tuition plans and college savings plans. Some states offer both, and many of these plans are open to non-residents. Here we compare and contrast these two plans. In addition to 529 plans, also explore Coverdell Education Savings Accounts (ESAs), Custodial Accounts, Series EE and I Savings Bonds, and college tax credits.

Prepaid Tuition Plans

A popular type of 529, the prepaid tuition plan allows for investors (parents, grandparents, etc.) to lock in on today's tuition rates at any of a state's eligible public colleges or universities. This plan was created specifically to help parents keep up with college tuition increases in public schools, so the rate is locked and investors do not have to worry about future tuition increases. The safest plans are guaranteed by the full faith and credit of the state, meaning that if a certain tuition plan has to shut down, investors can at a minimum get all the money they invested back.

How do prepaid tuition plans work?
  • Amounts are paid through installment payments in lump sums - you pay by years, credits, or units.
Do you have to save tuition for a 4-year undergraduate program?
  • Some states offer contracts for 2-year community college or a four-year undergraduate program, or a combination, and can cover 1-5 years of tuition. Some states allow the contract to be applied to graduate school tuition.
Do prepaid tuition plans cover expenses other than tuition?
  • Most prepaid college plans do not cover other expenses, such a room and board. Consider other college savings options to cover these costs.
Can you apply to a prepaid college tuition plan in another state?
  • Most prepaid tuition plans require either you or your child to be a resident of the state offering the plan when you apply. Some limit enrollment to a certain period each year.
How is the price of a prepaid tuition plan determined?
  • Under prepaid plans, the price of the contract is determined prior to purchase and usually depends on the type of contract, the current grade of the beneficiary (many plans also have age or grade limits for beneficiaries), the current and projected cost of tuition, and the projected rate of return, so that the earnings meet or exceed state college tuition increases.
What happens when the child ready to use the money from a prepaid tuition plan?
  • When a child goes to college, the plan transfers funds directly to the institution. If your child chooses not to attend an in-state public school, you can use plan money to pay college tuition at most private and out-of-state public schools. All prepaid plans let you transfer the plan to a child's brother or sister (although age restrictions may prevent transfers to an older sibling). If your child chooses not to go to college and a sibling doesn't use the plan, or you need to cancel the prepaid plan, most states will only give you back what you originally contributed. Some plans also charge a cancellation fee.

College Savings Plans

Students of all ages can save for college costs (including tuition, fees, room, board, textbooks, and computers) with a college savings plan. This type of 529 plan allows anyone considering going back to college or graduate school to save on taxes and allows you to transfer the money, tax-free, to another 529 plan for your children or spouse.

Withdrawals from college savings plans can be used at most colleges and universities throughout the country, including graduate schools. Some foreign education institutions also may be eligible. Many states now offer at least one college savings plan that has no residency restrictions. You can contribute to a plan in a state different than where you live, or where the student eventually goes to school, but local plans generally have tax advantages for residency.

Like mutual funds, some college savings plans have different classes. Often referred to as Class A, B, or C shares, units or fee structures, each class has different fees and expenses. You can look at the offering document to see if a particular college savings plan offers more than one class. It is very important to take fees and expenses into account when selecting a college savings plan. Slightly larger fees and expenses can make a big difference in the value of your investment over time. Fees include minimal enrollment fee, annual maintenance fees, sales charge (load), deferred sales charge, administration / management fees (Expense Ratio) and underlying expenses from the fees on the mutual funds the money is invested in.

Let's say you invest $10,000 in a college savings plan with a return of 10% before expenses. With a plan that had annual operating expenses of 10.97% (Yes, one plan has expenses that can be this high!), after 18 years, you would end up with only $6,866. That's over $3,000 less than you started with. If the college savings plan had expenses of 0.85%, you would end up with $47,680 - an 85% difference!

How do college savings plans work?
  • The tax advantaged money is deposited into an investment account on behalf of a beneficiary. Contributions can vary and are only limited by the maximum and minimum contributions limits set by most plans. Investment options often include stock mutual funds, bond mutual funds, and money market funds, as well as, age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age.
What are the minimum and maximum contribution limits of a college savings plan?
  • Minimum limits in most states are flexible, many require $250 initial contribution with subsequent contributions as little as $50, which can be reduce further if you contribute through pay reductions or auto-transfers. In most states the maximum amount that you can contribute $300,000 or more for one beneficiary . The IRS only requires that contributions for one child do not exceed the amount necessary for higher education expenses for that child, but if you want your child to go to an expensive college and graduate school, one option you have is to open more than one college savings plan.
What investment options are there for college savings plans?
  • Each plan gives you a number of investment options that allow you to invest in various portfolios of mutual funds. Some college savings plans offer age-based portfolios of mutual funds. When the child is younger, the portfolio typically invests mostly in stock funds, which carry a higher risk, but higher return potential. As your child grows older, the asset allocation becomes increasingly conservative as it gradually shifts to bond funds and other fixed-income funds. Many states also offer non-age-based investment options, allowing you to select portfolios with conservative, moderate, and aggressive asset allocations. Some states also offer investments options that allow you to invest in certificates of deposits whose interest rates are linked to an index that measures the average cost of college tuition.
What are the risks of a college savings plan?
  • College savings plans do come with some risk. Unlike prepaid tuition plans, they don't lock in tuition prices. Nor does the state back or guarantee the investments. There also is the risk with most college savings plan investment options that you may lose money, or it may not grow enough to pay for college. For example, if you choose a plan option that invests in stock mutual funds, chances are that your invested funds annual performance will mirror the trends of the stock market. Thus, you may lose money during a declining market.

Comparison of Prepaid Tuition and College Savings Plans

Prepaid Tuition Plan College Savings Plan
Locks in tuition prices at state's public colleges and universities. No lock on college costs.
All plans cover tuitions and mandatory fees only. Some states allow you to purchase a room & board option or use excess tuition credits for other qualified expenses. Covers all "qualified higher education expenses," including:
  • Tuition
  • Room & board
  • Mandatory fees
  • Books, computers (if required)
Most plans set lump sum and installment payments prior to purchase based on age of beneficiary and number of years of college tuition purchased. Many plans have contribution limits in excess of $200,000.
Many plans guaranteed or backed by state. No state guarantee. Most investment options are subject to market risk. Your investment may make no profit or even decline in value.
Most plans have age/grade limit for beneficiary. No age limits. Open to adults and children.
Most plans require either owner or beneficiary of plan to be a state resident. No residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers.
Most plans have limited enrollment period. Enrollment open all year.