Prepaid Tuition Plan vs. 529 Plan: Which One is Best?

The main difference between prepaid tuition plans and 529 plans is that prepaid tuition plans allow you to lock in tuition credits at today’s prices.

Prepaid tuition plans and 529 college savings plans are special savings accounts that are used to pay for future college costs. Prepaid tuition plans work like defined benefit plans, while 529 plans work like defined contribution plans.

There are other important similarities and differences between them. Get the details of each to find out which plan is more suitable for your college needs.

Prepaid tuition plans enable you to buy tomorrow’s tuition at today’s prices. This locks in the cost of college, so that one year of tuition is always worth one year of tuition. Prepaid tuition plans provide peace of mind by locking in tuition rates.

The money is invested by the plan administrator to attempt to provide a hedge against college tuition inflation. This works well when the stock market is rising rapidly and tuition increases are modest.

But, during economic recessions and for a few years afterward, tuition rates rise at an above-average rate and stock prices fall, causing prepaid tuition plans to go under the hammer.

Many prepaid tuition plans suffer from actuarial shortfalls, where prepaid tuition plan assets are insufficient to cover projected future college costs.

Some prepaid tuition plans are guaranteed by the full faith and credit of the state, but it is not clear what this actually means in practice.

Prepaid tuition plans typically react to actuarial shortfalls by discontinuing new investments, terminating plans, and reducing the value of benefits. Prepaid tuition plans also charge a premium on top of current tuition rates to cover the anticipated shortfall.

Premiums have increased, so the financial benefits of a prepaid tuition plan are no longer as good as they used to be. The refund value of prepaid tuition plans is also limited.

Of the nearly two dozen original prepaid tuition plans, only eight are still open to new participants, including eight state prepaid tuition plans and the private college 529 plan.

A 529 plan offers tax and financial aid benefits to help families invest money to pay for future educational expenses. Contributions to a 529 plan are made with after-tax dollars. In two-thirds of the states, contributions are eligible for a state income tax deduction or tax credit.

Income grows on a tax-deferred basis. If 529 plan distributions are used to pay for qualified education expenses, they are tax-free. 529 plans do not have annual contribution limits, but contributions are subject to gift tax limits.

A contributor can give up to the annual gift tax exclusion per beneficiary without incurring the gift tax. 529 plans also provide for five-year gift-tax averaging, sometimes called superfunding, which is considered to occur sequentially over a five-year period. 529 plans have total contribution limits that vary by state. Most 529 plans offer a menu of one to two dozen investment options, such as stock and bond mutual funds.

All 529 plans offer dynamic investment options, such as age-based or enrollment-date asset allocation, in addition to fixed investment options. There are two main types of 529 plans, direct-sold and advisor-sold. Direct-sold plans are managed by the state and have lower fees than advisor-sold plans, which are managed by a financial advisor.

Minimizing costs is the key to maximizing net returns. Most families should choose a 529 plan that charges less than 1%. There may be a compromise between lower fees and state income tax exemption.

In general, families should choose a 529 plan that charges lower fees until the child reaches high school, when the state offers a state income tax exemption on contributions then they should switch new investments to an in-state 529 plan.

Wyoming is the only state that does not offer a 529 plan. Most offer a direct-sold 529 plan and one or more advisor-sold 529 plans.

Prepaid tuition plans and 529 plans both offer tax and financial aid benefits as well as other flexibilities. If distributions are used to pay for qualified education expenses, they are tax-free.

The income portion of a non-qualified distribution is subject to income tax at the recipient’s rate, plus a 10% tax penalty, plus the possible recapture of the state income tax exemption.

If a dependent student has a prepaid tuition plan or a 529 plan, it is reported as basic assets on the FAFSA. This results in less impact on eligibility for need-based financial aid. The account owner 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. Prepaid tuition plans and 529 plans both offer automatic investment options and families can save from both. However, there are important differences between the two.

State residency is a major factor, as prepaid tuition plans are limited to state residents, while most 529 plans are not. The only exceptions are the Massachusetts Prepaid Tuition Plan and the Private College 529 Plan.

Eligible colleges also vary. Prepaid tuition plans can be used at public colleges only if purchased. If the student attends a private college or an out-of-state college, the family must pay the difference in cost. However, prepaid tuition plans can be converted to a 529 plan.

Time and age limits also exist. Most prepaid tuition plans must be used within 10 years of normal college enrollment, with some states limiting this to 8 years, 15 years, or 30 years. The limit on private college 529 plans is 30 years. Some prepaid tuition plans also have age limits, such as age 30 unless 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.

Additionally, 529 plans can be used to pay up to $20,000 per year in K-12 expenses and up to $10,000 in student loan repayments (lifetime limit per borrower) for the student and the student’s siblings.