What is a 529 Plan?

by | Jan 30, 2024 | Blog

One of the more popular ways to save for college education is by utilizing a 529 plan.  Many of you have probably heard of a 529 plan, but do you know what they are or how they work?  If not, keep reading!

What is a 529 Plan?

A 529 plan, also known as a qualified state tuition program, is a program maintained by a state or state agency that meets certain requirements and that allows an individual taxpayer to purchase tuition credits or certificates on behalf of a designated beneficiary OR make contributions to an account established to fund the qualified college education of a designated beneficiary.

Mixed within that definition of a 529 plan were TWO different types of 529 plans.  We’re going to break down the two for you.

The two types of 529 plans are college savings plans and prepaid tuition plans.  While one type of plan is much more popular than the other, it’s important to understand both types.

What is a prepaid tuition plan?

A prepaid tuition plan is a program that allows individuals to contribute all or part of a student’s tuition for college or university. The amount paid is guaranteed to track inflation of the specific college’s tuition. Prepaid tuition programs are primarily for students who plan to go to an in-state college or university and only cover the cost of tuition.

When it comes to taking on risk, a more risk averse investor would be interested in a prepaid tuition plan instead of a college savings plan.  The money in the prepaid tuition plan really isn’t subject to market risk since it is tracking inflation of the specific college’s tuition.  The upside growth of the money is limited, of course, but so is the downside compared to the other type of 529 plan.

What are some other characteristics of the prepaid tuition plan?  When applying for financial aid, the prepaid tuition plan is considered a parent or grandparent’s asset.  Prepaid tuition plans may be limited to undergraduate programs and are usually restricted to tuition and mandatory fees.  That does not include room and board.

Which school you choose impacts the “return” on your investment.  Since the return is tied to the inflation rate of the college’s tuition, a college that has higher tuition inflation would require a higher return for the prepaid tuition plan.  The method of payment for a prepaid tuition plan can be made either in a lump sum or in an approved installment plan depending on the school.

Prepaid tuition plans are only offered in nine states and beneficiaries must attend in-state institutions.

The biggest advantage of a prepaid tuition plan has to be the hedge it provides against inflation.  While investing the money COULD provide a hedge against inflation, a prepaid tuition plan locks that in and doesn’t depend on market returns.

The biggest disadvantage to a prepaid tuition plan is the restrictive nature of the plans.  Like we said before, only nine states offer these plans, and if the college you want to attend doesn’t have one – you can’t use it.  Not only does a prepaid tuition plan restrict the specific schools they can be used at, but they also restrict what the money can be used for within those schools.

Ultimately, prepaid tuition plans make up a very small amount of 529 plan money, but it’s important to know BOTH types of accounts so you can make the best-informed decision possible.

What is a college savings plan?

A college savings plan is the other, more popular, version of the 529 plan.  As recently as the end of 2020, roughly 93% of 529 plan funds were in college savings plans.  These types of plans certainly favor the more risk tolerant investor.  The money in your 529 college savings plan is invested in the market.  However, most 529 plans offer an age-based allocation depending on how old the beneficiary is.  Let me explain.

For a beneficiary who was just born, less than one year old, an “Age 0” allocation would be significantly more invested in stocks than an age-based allocation for a 17-year-old.  These allocations begin riskier, sometimes close to 90% stocks and 10% fixed income.  Over time, they shift the allocations for the investors automatically.  A 90/10 stock/bond split slowly becomes 70/30, and then 50/50, and by the time the beneficiary needs the money for college it’s almost entirely in fixed income.  This is designed to grow the money while the beneficiary has a longer time horizon, and preserve the money when they need it most.

Each state has its own 529 plan.  While you are free to use the 529 plan in the state you live, you are NOT required to use it.  You can open a 529 plan using ANY state’s plan.  Somebody who lives in Florida is more than welcome to open a 529 plan using New York state’s 529 plan.

Like a prepaid tuition plan, the college savings plans will count towards the parents or grandparent’s assets when considering financial aid for the beneficiary.  But unlike the prepaid tuition plans, college savings plans are not restricted to just tuition – and sometimes can be used for room and board and other qualified education expenses.  The choice of school does NOT impact investment returns.

When utilizing the funds in a college savings plan, if used for a qualified education expense, the money is tax free.  If you withdraw 529 plan money for an unqualified expense, you’ll incur a 10% penalty and must report those funds as income on your state and federal taxes.

College savings plan used to only be used for four-year traditional college education.  That turned some folks off because what happens if their child doesn’t attend a four year school?  However, recently they have become much more lenient with what is allowed with 529 plan funds.  On top of regular college education, you can also use up to $10,000 a year on things like elementary school, middle school, high school, or even trade school.

Starting in 2024, unused 529 plan balances can be eligible to be rolled into a Roth IRA for the beneficiary as well.  There are some rules attached to this, however.  The account must have been open for at LEAST 15 years before being eligible for this type of rollover.  The lifetime limit of these rollovers is $35,000 as well.

There are plenty of options when it comes to savings for education.  Prepaid tuition plans and college savings plans are just two of the more convenient ways to do it.  It’s important to understand all of your options when making decisions like this.

While we discussed a lot of details in this post, this is by no means an exhaustive list of all the ins and outs of 529 plans.  If you have more questions about 529 plans and saving for college, let us know!  Click the “Schedule a Consultation” button at the top of this page to get in touch with us.

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