Today, there are many investment vehicles available for college savings. As with all investment options, all of these strategies are not created equal. The tax advantages, high contribution limits, and flexibility of 529 plans have provided an attainable strategy to fund the ever-increasing cost of American college education.

The total cost of college (tuition, room & board, books, transportation, etc.) has been rising at a rate which continues to surpass cost of living averages. Consequentially, it’s become even more imperative to take advantage of tax-advantaged accounts. Through tax-advantaged strategies, such as those associated with 529 plans, it is possible to accumulate more money with a tax-advantaged investment compared to a taxable investment.

What are 529 Plans Exactly?

A 529 plan is a federal tax-advantaged college savings vehicle which allows tax-free growth of earnings as well as tax-free withdrawals, among many other benefits. There are two types of 529 plans: college savings plans and prepaid tuition plans. Though college savings plans and prepaid tuition plans share the same federal tax advantages, there are important differences to understand about each.

529 Plans: College Savings Plans

College savings plans allow you to save money for college in an individual investment account (either through a financial professional or directly). 529 college savings plans offer a unique combination of benefits including the following:

  • Contributions to your account grow tax deferred.
  • Withdrawals used to pay qualified education expenses are completely tax free.
  • State tax advantages such as tax deductions for contributions or a tax exemption for qualified withdrawals.
  • Favorable federal gift tax treatment: Contributions to a 529 plan are considered completed, present-interest gifts for gift tax purposes. This means that contributions qualify for the $14,000 annual gift tax exclusion. And with a special election, you can contribute a lump sum of $70,000 to a 529 plan, treat the gift as if it were made over a five-year period, and completely avoid gift tax.
  • Favorable federal estate tax treatment: Your plan contributions aren’t considered part of your estate for federal tax purposes. You still retain control of the account as the account owner but you don’t pay a federal estate tax on the value of the account. But if you spread today’s gift over five years and you die within the five years, a portion of the gift will be included in your estate.
  • High contribution limits (most college savings plans have a maximum contribution limit of $300,000).
  • There are no income level restrictions.
  • Flexibility: Under federal rules, you can change the beneficiary of your account to a qualified family member at any time without penalty. And you can rollover the money in your 529 plan to a different plan once per year without income tax or penalty implications.
  • Wide use of funds: Money in a 529 college savings plan can be used at any college in the U.S. or abroad that’s accredited by the U.S. department of Education and, depending on the individual plan, for graduate school.

529 Plans: Prepaid Tuition Plans

Prepaid tuition plans are distant cousins to college savings plans–their federal tax treatment is the same, but just about everything else is different. A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you pay tuition expenses at participating colleges at today’s prices for use in the future. Prepaid tuition plans can be run either by states or colleges. For state-run plans, you prepay tuition at one or more state colleges; for college-run plans, you prepay tuition at the participating college(s).

As with 529 college savings plans, you’ll need to fill out an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units (which you can then do again periodically), subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future, no matter how much college costs may increase between now and then. As such, prepaid tuition plans provide some measure of security over rising college prices.

Prepaid tuition plans have some limitations, though, compared to 529 college savings plans. One major drawback is that your child is generally limited to your own state’s prepaid tuition plan and to certain colleges in which your plan participates in. If your child attends a different college, prepaid plans may differ on how much money you’ll get back. Additionally, some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan’s offered benefits. Even with these limitations, some college investors appreciate the peace of mind that comes with not worrying about college inflation each year by locking in college costs today.

College Savings Plans Prepaid Tuition Plans
Offered by States Offered by states and private colleges
You can join any state’s plan State-run plans require you to be a state resident
Contributions are invested in your individual account in the investment portfolios you have selected Contributions are pooled with the contributions of others and invested exclusively by the plan
Returns are not guaranteed; your account may gain or lose value depending on how the underlying investments perform Generally, a certain rate of return is guaranteed
Funds may be used at any accredited college in the U.S. or abroad Funds can only be used at participating colleges, typically state universities

Choosing a College Savings Plan

Although 529 plans are a creature of federal law, their implementation is left to the states. Currently, there are over 50 different college savings plans available, because many states offer more than one plan. Fortunately, the state in which you reside in does not hinder you from purchasing another state’s 529 plan. Often times, another state’s plan(s) may have greater benefits such as a deduction for contributions. Additionally, 529 plans vary in the investment options they offer. Ideally, you’ll want to find a plan with a wide variety of investment options to suit your specific needs.

Before selecting a plan, it is essential to review the fees and expenses of the plan, as these tend to vary widely from plan to plan. Watch for underlying fee expenses as well as annual maintenance fees (administration and management fees). With so many plans available, it may be helpful to consult an experienced financial professional who can help you select a plan and help pick out your investments. Reilly Financial Advisors, an independent Registered Investment Advisor, helps clients both define and achieve their individual financial goals, which oftentimes include funding college education for children and grandchildren. Contact us to learn how we can help you meet this unique need.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated.