Here’s something that’s painfully obvious to all parents: college is expensive. The total average cost of a four-year, in-state public college is $90,760, according to the College Board. And, that cost is expected to only grow larger as college tuition and fees outpace inflation.
The high price tag of higher education is why very few families can simply write a check or save for college in a regular bank account.
KEY TAKEAWAYS
- A 529 plan is a state-sponsored tax-advantaged investment account designed for college and other higher-education expenses
- A prepaid 529 tuition plan allows you to pre-purchase future tuition at a predetermined rate today
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Traditional 529 plans give you much more flexibility but prepaid 529 plans provide valuable protection from tuition inflation
One common solution is the 529 plan. It is designed for growing your savings to help pay for college and other higher-education expenses. They are usually sponsored by states, with some states also offering prepaid tuition plans.
If you have a choice between a traditional 529 plan and prepaid 529 plan, it helps to understand their differences to determine which one is right for your child.
What to know about a traditional 529 plan
A 529 plan is a state-sponsored tax-advantaged investment account designed for college and other higher-education expenses. The savings in a 529 account can be used for tuition, books, and other education-related expenses at most accredited colleges and universities, U.S. vocational-technical schools, and eligible foreign institutions.
College savers are attracted to 529 plans for several reasons, but the tax advantages may be the biggest draw. Your earnings can grow tax-deferred and some states allow you to deduct your contributions. Also, withdrawals for qualified higher-education expenses are tax-free.
One thing to keep in mind is that 529 funds are counted as an asset, which can impact a student’s financial aid eligibility. the amount of financial aid offered depends on the resources a family has to cover college expenses.
Generally, the greater the amount of assets and income a family has, the more the family is expected to contribute toward college expenses and the less financial aid the student receives. In that calculation, the student’s reported assets and income can reduce financial aid eligibility the most. Therefore, who owns the account matters.
If the parent owns the account and the child is the beneficiary, the asset is counted as the parent’s asset. If the student owns the account, the value of the account is included when determining the student's expected contribution amount. When a grandparent owns the account, the 529 account withdrawals are treated as student income for financial aid purposes. (Note: Starting in the 2024-2025 school year, money distributed to students from grandparent-owned 529 accounts won’t reduce the recipient’s federal financial aid eligibility.)
States offer different 529 savings plans, and you don’t need to be a resident of that state in order to qualify for an account. However, certain states may offer tax benefits for in-state contributions. So, you may want to work with a financial adviser to adviser to set up a 529 plan that’s most appropriate for your child.
What to know about a 529 prepaid tuition plan
Some states offer plans that allow you to pre-purchase future tuition at a predetermined rate today. Typically, an account owner will purchase somewhere between one and four years of tuition for a young child, and when that child reaches college age, the plan pays out based on tuition rates at that time.
As with traditional 529 college savings plans, earnings in a prepaid tuition plan grow tax-free, and you won’t pay any taxes on withdrawals as long as they’re used for qualified educational expenses.
When it comes to financial aid, these plans are treated the same as other 529 plans, counted as an asset in calculating your expected contribution.
Unlike 529 college savings plans, most state 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.
Many prepaid tuition plans also have age or grade limits for beneficiaries (i.e., future college students). With only a few exceptions, most prepaid tuition plans do not cover other expenses, such as room and board. So, you may want to consider other college savings options to cover these costs.
Which is right for you?
Ultimately, a traditional 529 plan gives you much more flexibility, as it can be used for out-of-state or private colleges and expenses beyond just tuition.
However, a prepaid 529 plan provides valuable protection from tuition inflation. You also don’t have to worry about investing your college savings. But that’s only if you’re confident that your child will attend an eligible university in your state.
For both types, if your child receives scholarships or chooses not to attend college, you can transfer the account to another beneficiary. Any funds used for ineligible expenses may be subject to taxes and a 10 percent penalty.
That’s why some college planning should go along with your college savings. A financial adviser can help parents determine how much they can save for college, how best to invest money in a 529 plan and how to still achieve their other big financial goals, such as retirement.
Learn more about college planning by downloading our free ebook: Saving for College: Financial Tools to Help Secure Your Student’s Future. It takes you through the most common college savings tools and their impact on financial aid.
