A qualified tuition program, also referred to as a 529 plan, is a state-sponsored tuition plan that can provide a tax-advantaged way to save money for college and other qualified educational expenses. There are significant differences between the two types of 529 plans—prepaid tuition plans and savings plans.
529 Prepaid Tuition Plans
Prepaid tuition plans allow parents, grandparents and others to prepay tuition at today’s tuition rates at eligible public and private colleges or universities, helping them manage future tuition costs. Most states guarantee that the funds you put into a prepaid plan will keep pace with tuition.
With a prepaid tuition plan, you pay for amounts of tuition (years, credits or units) in one lump sum or through installment payments. Some prepaid tuition plans offer contracts for a two-year community college or a four-year undergraduate program, or a combination of the two, and can cover one to five years of tuition. Some plans even allow the contract to be applied to graduate school tuition.
With only a few exceptions, however, most prepaid tuition plans don’t cover other expenses, such as room and board.
Unlike 529 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.
When a child is ready to go to college, the plan transfers funds directly to the institution to cover the tuition. If your child chooses not to attend a college covered by the prepaid tuition plan, however, all is not lost. Although you won’t get the benefit of guaranteed tuition, all prepaid tuition plans allow you to use plan money to pay tuition at other colleges and universities. Most prepaid plans also let you transfer the plan to a child's brother or sister (although age restrictions may prevent transfers to an older sibling).
Unfortunately, if your child chooses not to go to college and a sibling doesn't use the plan, or you need to cancel the prepaid plan, most plans will only give you back what you originally contributed with a reduction or elimination of any interest earned. Some plans also charge a cancellation fee.
With 529 savings plans, students of all ages—and their parents, grandparents, other relatives or even friends—can save for qualified college expenses, which generally include tuition, fees, room, board, textbooks and computers (if required by the school), as well as for textbooks, fees and equipment related to apprenticeship programs. These plans may also be used to pay for K−12 tuition, but the rules for doing so vary by state and/or plan.
If you intend to use a 529 savings plan for K−12 tuition, keep in mind that your time frame will be shorter than those who are saving only for college, and withdrawals might not be tax-free in your state. (Qualified withdrawals are free from federal taxes for everyone.) This will likely impact your investment choices and the level of investment risk that might be appropriate for your circumstances.
Qualified withdrawals from 529 savings plans can be used at most colleges and universities throughout the country, including graduate schools, as well as some overseas educational institutions. Many states now offer at least one 529 savings plan that has no residency restrictions. For example, you can live in Ohio, contribute to a plan in Maine and send your child to college in California. However, if your state offers state tax advantages to residents who participate in the local plan, you'll miss out if you opt for another state's 529 plan.
Investing in 529 savings plans does come with some limitations and risk. Under IRS rules, you can change your investment mix only two times per year. Unlike prepaid tuition plans, 529 savings plan don’t lock in tuition prices, nor does the state back or guarantee the investments. There’s also the risk with most 529 savings plan investment options that you might lose value or that your investment might not grow enough to pay for college.
When you invest in a 529 plan, you pay money into an investment account on behalf of a designated beneficiary—often your child, but any U.S. citizen or resident alien who has a Social Security number or federal tax identification number can be your beneficiary, even yourself. Contributions amounts are only limited by the maximum and minimum contributions limits set by most plans, which can vary from state to state.
The IRS currently limits contributions to a 529 plan to the amount necessary for the qualified higher education expenses of the child named as the beneficiary. However, you can open an additional 529 plan in another state for the same beneficiary. So, if you want your child to go to an expensive college and graduate school, opening more than one 529 plan is a way to increase the amount of contributions you can make.
Withdrawals for Student Loans and Rollovers
Funds in 529 savings plan can be used to pay for student loans, up to the IRS limit per loan borrower. This means that money in the 529 savings account can be put toward the loans of more than one borrower, including those of siblings, or even the parents or grandparents. Check with your individual state plan to determine whether or not it conforms with the federal definition of qualified expenses.
And beginning in 2024, if there are unused funds in a 529 savings plan that has been opened for at least 15 years, the beneficiary will be able to roll over up to $35,000 into a Roth IRA without penalty or tax liability, though rollovers will be subject to Roth IRA contribution limits.
Broker-Sold 529 Savings Plans
Some brokerage firms and advisers offer one or a limited number of 529 savings plans. Broker-sold 529 savings might or might not provide state tax advantages, and they might be more or less expensive than direct-sold plans sold by a state. If you're comfortable choosing a plan and selecting your investment options on your own, you can often save money investing in a direct-sold plan.
If you’re working with an investment professional, ask:
- Does my state plan offer advantages that I might not receive if I invest in an out-of-state plan?
- How many 529 savings plans do you offer?
- Can I claim a state-tax deduction on contributions to the 529 saving plan you're recommending? If not, how much of a deduction would I forego by investing in this plan instead of the plan sponsored by my state of residence?
- How much will I pay in fees and expenses? And how will these fees impact my return on investment and tax savings I might receive?
Independently verify sales information you receive by thoroughly reading the official disclosure documentation offered by the 529 plan. Brokers are required to provide this documentation to you, and it may also be available on the MSRB's EMMA website. Make sure the investment meets your objectives and that you understand and are comfortable with the risks, costs and liquidity of the investment. Never invest in a product you don't understand.