If you are starting an account to eventually fund your child’s education, you may have heard the 529 savings plan and 529 prepaid college tuition plan are the two best options.
Deciding which plan is the better choice for you depends on many factors, but first it is important to understand a few basic truths regarding financial products and these savings plans:
- All financial products, whether for college planning or not, have positives and negatives. Therefore, there is no silver bullet for college planning.
- College savings plans work best when coordinated with the other components of your financial plan, such as retirement planning, tax planning and access to cash.
- Both of these college savings plans fall under Section 529 of the tax code.
- Objectively speaking, one is not superior to the other, especially when the specific college is unknown.
529 Savings Plan
A 529 savings plan is a tax-advantaged method of saving for future college expenses. The plan allows an account holder to establish a college savings account for a beneficiary and use the money to pay for tuition, room and board, mandatory fees and required books and computers. The money contributed to the account can be invested in stock or bond mutual funds or in money market funds, and the earnings are not subject to federal tax (or state tax, in many cases) as long as the money is used only for qualified college expenses.
In plain English this means that a 529 savings plan is a tax-advantaged tool used to save and pay for educational expenses. (For related reading, see: Top 7 Mistakes to Avoid on Your 529 Plan.)
529 Prepaid College Tuition Plan
Prepaid tuition plans allow donors to lock in the future cost of tuition in today's dollars. Because the cost of tuition is increasing faster than the rate of inflation, the rate of return on these plans is generally greater than that of guaranteed instruments such as bonds or CDs. But these plans are also guaranteed by the financial backing power of each state.
In plain English this means a 529 prepaid college tuition plan is a tool that locks in today’s tuition rates for your future tuition payments.
There are many ways financial products can be compared:
- Risk of investment
- Tax advantages
- Upside potential
- Ease of management
- Potential penalties
- Effect on the financial aid formula
- Effectiveness at actually paying for educational expenses
Knowing which of these criteria are more important to you and which ones are less important can help in making financial decisions.
529 Savings Plan's Best and Worst Features
With 529 savings plans, you must pay for a qualified educational expense in the year it is incurred to avoid penalty and taxation. Putting a definition and timeline around what you can actually use the money for without penalty introduces some complexity and limitations. (For related reading, see: 529 Plans: Distributions.)
The 529 savings account's best attribute is typically its upside potential. 529 savings plans offer strong tax advantages, great upside potential and can be very easy to manage and administer. These plans can also be transferred from sibling to sibling without taxation.
Its worst attribute is typically its risk level—100% of principal at risk. As a market-linked investment, it takes on a much higher level of risk compared to other tools. For example, you could lose 10-30% of the account balance right before any year of college if the market has a down year. If you choose to use a 529 savings plan, you must plan around this risk.
529 Prepaid College Tuition Plan's Best and Worst Features
The 529 prepaid college tuition program's best attribute is typically its ease of management. They are “set it and forget it.” There’s no portfolio to rebalance and you can create a plan to have the same contribution level every month. Also, these plans can be set up for public or private schools. Anytime you can automate a financial process is a huge plus.
Its worst attribute is typically its lack of flexibility, control and liquidity. These plans generally cover tuition only, cannot be used for other expenses and can be very inflexible if your circumstances change over time. If your child gets a scholarship, joins the military or does not go to college, you could be forced to forfeit most of the gains inside your plan. Also, there is no liquidity in this type of plan for other child-related expenses, emergencies or opportunities that might occur while you are planning for college.
Choosing which plan is right for you and your child depends on a variety of factors, as evidenced by the complexity of each plan. To make the most out of your money, you should carefully consider your financial situation and decide which plan is most appropriate for you.
(For related reading, see: How 529 Plans Impact Financial Aid.)
Disclaimer: Registered representative of and offers securities and investment advisory services through MML Investors Services, LLC, a Member SIPC. OSJ Urban Center One Suite 800 4830 West Kennedy Blvd Tampa FL 33609 813- 286-2280. The views and opinions expressed are those of Erik Fischer, CFP®. The views of Erik Fischer, CFP® are not necessarily those of MML Investors Services, LLC or its subsidiaries. Interlink, Wealth Management LLC is not a subsidiary or affiliate of MML Investors Services, LLC, or its affiliated companies.