As parents look for ways to save money for their children’s college educations, many are discovering 529 savings plans. In every state and the District of Columbia, individuals are able to invest in these state-operated accounts that provide tax advantages when the funds are used for approved educational expenses.
Additionally, in 11 states — Virginia, Maryland, Massachusetts, Mississippi, Florida, Washington, Michigan, Nevada, Illinois, Pennsylvania and Texas — parents have the option to invest in a prepaid 529 plan. These accounts differ from traditional 529s in that parents purchase tuition credits that will cover their child’s future tuition, typically at an in-state, public university, at current rates.
[Find out how to get a break on private college tuition with prepaid plans.]
But while prepaid plans allow parents the opportunity to get around the skyrocketing costs of college tuition by locking in present-day prices, there are some major differences between those plans and regular 529s that could prove disadvantageous for some families.
1. Flexibility: Some of the most significant differences between prepaid plans and 529 savings plans are related to available options for using the account’s funds.
“One area of flexibility where traditional 529 plans are better is that their funds can be used to pay for tuition, books, equipment, fees and room and board at a wide variety of qualifying institutions, such as private or public colleges, graduate and professional schools, technical and trade schools, and foreign universities,” says Peter Lazaroff, a certified financial planner with Plancorp LLC in St. Louis. Typically, prepaid tuition plans only fully cover tuition at in-state public colleges, he says.
This in-state distinction also may come into play when students with prepaid plans move to another state before they enroll in college. In some cases, even when the child enrolls in a university in the state that’s covered by the plan, if the student no longer qualifies as a resident of that state, he or she is liable for the difference between the in-state fees that the prepaid plan will cover and the out-of-state fees the university charges.
Finally, prepaid accounts generally offer less flexibility regarding beneficiaries. In the event that a student no longer needs the funds within a traditional 529, the account can be transferred to anyone of any age within the original beneficiary’s family. With prepaid plans, however, things get decidedly more complicated.
[Discover four things to consider when changing 529 plan beneficiaries.]
In Virginia, for example, “in the event of the death or disability of the beneficiary, or the receipt of a scholarship by the beneficiary, the prepaid semester will be repaid to the account owner,” says Daniel Morgan, m anaging d irector of Reston, Virginia’s Independent Financial Planning. In th at state , this repayment includes the principal investment, plus any gains on the principal. And while the repayment will be made without any state taxes assessed, the earnings will, however, be taxed at the federal level as ordinary income.
2. Account growth and risk: Most parents who opt for a prepaid tuition plan are not choosing that vehicle for the potential growth of the account through investment gains. Instead, the benefit is in the guarantee of a lower tuition rate than what is anticipated in the future. But if a child does not use the tuition credits purchased with the prepaid plan, the fact that those accounts generate very little growth can be a problem .
“In Virginia, if the potential student does not attend a public, state school, the growth received on the contribution is the ‘reasonable rate of return,'” says Morgan of the amount that would be repaid to the account holder. “This rate of return is the Institutional Money Funds Index reported by iMoneyNet, and the rate has been .05 percent and below since January 2010.” On the other hand, traditional 529s can conservatively assume a return of around 6 percent, depending on on the account’s investment mix.
[Explore five options for risk-averse college savers.]
But higher returns also mean higher risk. A 529 that is heavily weighted in stock investments may have much higher earning potential than a prepaid plan, but with prepaid plans, parents are shielded from investment risk as returns are consistently positive — even if significantly below the rate of inflation.
Still, parents should be aware that many prepaid tuition plans do not come with a legal guarantee that they will be fully funded by the state in the event of a shortfall. In Alabama, for example, families had to settle for partial payments when the state’s plan ran into financial trouble.
3. Enrollment: While parents are free to begin investing in a traditional 529 whenever they wish, enrollment periods for prepaid plans are much more restrictive. Each state varies, but the programs are typically only open for a few months out of the year — five in Florida, for example. And the age of the student also can affect enrollment. Generally speaking, tuition credits for older students cost less — but only to a certain point. Students who are in the ninth grade or older are may not be eligible for a prepaid plan at all.
Those guidelines may make prepaid plans a less viable option for some parents, but there are still instances when they should be considered, says Sean Moore, a certified financial planner in Boca Raton, Florida. One of the reasons so few states currently have a prepaid plan, Moore says, is that many weren’t actually good investments for residents. But with the passage of a new law, the state of Florida is working to rectify that issue.
“The Florida Prepaid Plan is one of the only prepaid plans ?that has seen a major price reduction recently,” says Moore. To buy a Florida Prepaid Plan, which covers four years at a university, for a newborn cost $53,729 in 2013. “This past year, that same plan cost just under $27,000. Monthly payment options dropped from $350 per month to $173 per month. At previous price points, the plan just didn’t make financial sense. Today, it does.”
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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3 Key Differences Between Prepaid, Regular 529 Savings Plans originally appeared on usnews.com
