529 Plans (College Savings Plans)

Named for a section of the federal tax code, 529 plans are savings plans for the exclusive purpose of college expenses. Technically known as "qualified tuition programs," these plans have many tax advantages: earnings and withdrawals are exempt from federal taxes as long as they are used for qualified expenses.

Two types of 529 plans exist: prepaid tuition plans and college savings plans. Prepaid tuition plans are purchased from a state agency or coalition of private colleges. Buyers purchase a specific share of future tuition expenses at the current price for tuition. Plans include purchasing credits, units, or a specific number of semesters of tuition at a qualified college. College savings plans can be purchased from financial advisors or state agencies. Buyers contribute money to a saving plan that invests the funds. Contributions and any returns can be withdrawn for college tuition, room, and board at any qualified college or university.

Background

Prepaid tuition plans sell tuition for future use at a college within the plan, usually an in-state college or university. One plan covers tuition at a member college for a coalition of private educational institutions. Depending on the plan, purchasers can buy tuition for varying amounts, from one course to five years. These plans generally lock in the price of tuition at current rates. The plan cost is based on the age of the college-bound beneficiary. Plans may be purchased before a child is even born or, for some plans, up to one year before college age. The closer to college age, the higher the cost.

These plans sell only tuition. Funds in the plan cannot be used for other college-related expenses, such as room and board. As of 2015, many states have restricted prepaid tuition plans to existing members and are not offering them to new purchasers. Less than ten states offer prepaid tuition plans to new enrollees.

Prepaid tuition plans are purchased directly from the state, the coalition of private colleges, or from some colleges. A variety of types of plans are available. The contract plan is one in which a person purchases a contract that pays a tuition fee in advance of a student’s enrollment. Contract plans typically charge more than the current rates for future tuition. In return, the state guarantees payment for the beneficiary’s tuition expenses at the rate charged following the beneficiary’s high school graduation. The unit plan involves the purchase of a share of future tuition expenses, such as a semester or a percentage of the yearly tuition. The voucher plan sells vouchers, or coupons redeemable only at that college for a share of future tuition expenses.

There is a set price to participate in prepaid tuition plans, and it is determined at the time of purchase based on the type of plan, the future tuition shares purchased, the beneficiary’s age, the current costs of college tuition within the plan’s area, the projected costs of college tuition, and the anticipated rate of return on the plan’s investments. Unlike college savings plans, prepaid tuition plans do not earn interest for the account holder. Individual purchasers know the value of their plan at the time of purchase. They do not, however, know what the costs of tuition will be at the time of the withdrawal.

If a beneficiary decides not to attend a college in the plan’s network, the money in a prepaid tuition plan can be withdrawn to pay for tuition at another educational institution. The money is weighted to be comparable to the tuition costs at a member college or university, but some value may be lost. If a beneficiary decides not to attend any college, the beneficiary can be changed to another relative. Some restrictions may apply, particularly related to the age of the relative. If no other beneficiary exists or is eligible, the money can be withdrawn and returned to the plan’s owner. Typically the money put into the plan is returned, minus a percentage of the fund’s return. In addition, a cancellation fee may be charged.

In many ways, putting money into a college savings plans is similar to investing in an Individual Retirement Account (IRA). One picks a plan, makes contributions, and withdraws funds when eligible. College savings plans, however, have some unique features and restrictions. For example, the money that is withdrawn can be used only for qualified college expenses.

Plans are available through a financial advisor or directly from a state agency. Plans purchased through financial advisors typically have higher returns and higher costs than those purchased from a state agency. Although financial-advisor plans have higher returns, their costs often offset any benefit from those returns.

The person who makes the contributions is called the plan’s owner. The named recipient is the beneficiary. The plan’s owner controls the assets in the savings plan for the benefit of the beneficiary.

Individuals can purchase a state plan through any state, regardless of the state in which they reside or the state in which the beneficiary plans to attend college. Many states offer tax benefits, such as credits or deductions, which make their plans more attractive for in-state savers. A few states offer incentives for both in-state and out-of-state residents. When comparing plans, it is important to see whether the state tax benefits offset high administrative fees or other costs.

The plan’s owner can change the beneficiary if the intended recipient decides not to go to college. However, each plan has limitations on when these changes can be made and who is eligible to be a beneficiary. A beneficiary must be a family member. If the beneficiary decides not to withdraw the funds for qualified college expenses and no other eligible beneficiary is named, the funds can be withdrawn, but a penalty will be applied.

Other features to consider when researching a plan are the plan’s limitations, investment options, types of investment methods used, performance, and fees. Limitations include the minimum investment required and maximum contribution allowed. Some state plans allow initial investments as low as twenty-five dollars. Most plans do not require contributions be made at set intervals, but they may require that a minimum amount be added to the account over a designated period, such as two years.

Most plans offer a variety of investment options, such as stocks and mutual funds. Investment strategies are based on either age-based or static methods. Aged-based methods tend to be aggressive when a child is young and then gradually become more conservative as the child nears the age of college. Static methods use the same investment method throughout the plan period.

Plans vary on their fees. The most common types of fees are an enrollment fee, an annual maintenance fee, an administrative or management fee, an underlying fund fee, and a sales charge fee. The administrative or management fee typically incurs the highest costs.

Impact

Prepaid tuition plans were designed around the premise that it was possible to predict the future costs of tuition, allowing plan buyers to pay a predetermined amount to lock in future tuition expenses at current costs. While this premise was attractive, it did not live up to its expectations. Inflation and rapidly rising tuition costs have resulted in plans in which the funded money failed to meet the analysts’ projections and there was insufficient money in the plans to pay for the actual tuition costs when plan beneficiaries enrolled in college.

Some states guarantee their plans, and if the money in the plan is insufficient to pay for tuition at the time the beneficiary withdraws funds, the state makes up any deficits. Other states do not guarantee the funds but can ask the state’s legislature to approve funding for any deficits. A few states offer no guarantee that funds will be sufficient to pay for future tuition costs. If the future costs of tuition rise beyond what is in the plan, the beneficiary has to make up the difference.

While a buyer will not lose money in a prepaid tuition plan, there is no guarantee that the money put into the plan will be enough to cover the rising costs of tuition. Because the cost of tuition is rising faster than the forecast models used for prepaid tuition plans, many states are no longer offering these plans to new participants.

Another disadvantage of prepaid plans is that most plans allow funds to be used only for in-state public schools. Some states allow funds to be used for out-of-state schools at a lower redeemed value.

College savings plans have an advantage over prepaid tuition plans in that they cover all qualified college expenses, including room and board. They also offer a flexibility lacking in prepaid tuition plans. Beneficiaries are not restricted to in-state schools. They can be used at most institutions of higher education, including graduate school and some foreign colleges and universities. They also allow plan owners to add contributions to the saving plan after its purchase. Plan owners can purchase as many plans as desired. Owners who reach the maximum contribution in one state can purchase a plan in a different state.

Some states allow tax deductions or credits for contributions to college savings plans, making them more attractive than other savings plans.

Like any other investment method, college savings plans are not risk-free. It is possible to lose all the money invested or to earn less than one needs for college expenses.

Bibliography

Bogan, Vicki L. "Savings Incentives and Investment Management Fees: A Study of the 529 College Savings Plan Market." Contemporary Economic Policy, vol. 32, no. 4, 2014, pp. 826+.

"529 Plans." Financial Industry Regulatory Authority, 2015, www.finra.org/investors/investing/investment-accounts/college-savings-accounts/529-plans. Accessed 27 Oct. 2024.

"The 529 Solution." CNNMoney, money.cnn.com/pf/college/features/529plan/. Accessed 27 Oct. 2024.

Silvestrini, Elaine. “529 Plans: Everything You Need to Know about Saving for College.” Kiplinger, 19 Aug. 2024, www.kiplinger.com/personal-finance/careers/college/603628/529-plan-faqs. Accessed 27 Oct. 2024.

"Saving for Education- 529 Plans." United States Securities and Exchange Commission, Office of Investor Education and Advocacy, 2019, www.investor.gov/saving-education-529-plans. Accessed 27 Oct. 2024.