Question: We are starting an account to eventually fund our child’s education, and we have heard that the 529 Savings Plan and the Prepaid College Tuition Plan are the two best options. Is that true and which one is better?
Answer: This is a very frequent question that parents ask when they are taking the first steps towards college planning. These two options do in fact vary quite a bit from each other, and so in order to determine which one is most appropriate for your situation we should start with a few baseline assumptions:
- All financial products (whether for college planning or not) have positives and negatives. Therefore, there is no silver bullet for college planning.
- College planning does not happen in a vacuum. What I mean by this, is that the most successful college plans occur when the planning is coordinated with other components of your financial plan (for example retirement planning, tax planning and access to cash).
- Did you know that both plans fall under Section 529 of the tax code? We will refer to them throughout this article as “529 Savings” and “529 Prepaid.”
- Objectively speaking, one is not superior to the other, especially when the specific college is unknown.
- In order to make a judgement on which is more appropriate for your planning, we first need to understand their definitions. Let’s start there:
529 Savings Definition: 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 most cases) as long as the money is used only for qualified college expenses. (Source: Investopedia)
In plain English this means: a tax advantaged tool to save, accumulate and pay for educational expenses
529 Prepaid Definition: 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. (Source: Investopedia)
In plain English this means: a tool that locks in today’s tuition rates for your future tuition payments.
Comparing the Products: There are many ways that financial products can compared. When consulting with your financial planner, please ask them to explain the differences in these areas: risk of investment, tax advantages, upside potential, flexibility, liquidity/control, ease of management, potential penalties, effect on the financial aid formula, and effectiveness at actually paying for educational expenses. Knowing which of these criteria are more important to you and which ones are less important can be an indicator in your planning.
A Few Key Takeaways:
Both Products Are Good However, There Are Limitations That Can Affect The “Effectiveness at Actually Paying for Educational Expenses.” Here is Why:
In 529 Savings Plans, you must pay for a “qualified educational expense in the year that the expense is incurred” in order 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. The 529 Prepaid version takes it a step further – these plans generally cover tuition only and cannot be used for other expenses.
The 529 Savings’ Best Attribute Is Typically Its Upside Potential. Its Worst Attribute is Typically Its Risk Level (100% of principal at risk)
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, which is a nice level of flexibility. However, 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 had a down year. In the last 20 years, we have had 4 down years (1 in 5) and each down year the S&P lost at least 9% (Source: YCharts). If you choose to use a 529 Savings you must plan around this risk.
The 529 Prepaid’s Best Attribute Is Typically Its Ease of Management. Its Worst Attribute Is Typically Its Lack of Flexibility, Control, and Liquidity.
529 Prepaid Plans 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. However, Prepaid Plans 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 happen in your life while you are planning for college.