Different types of 529 plans: Prepaid versus savings

Amy Fontinelle

By Amy Fontinelle
Amy Fontinelle is a personal finance writer focusing on budgeting, credit cards, mortgages, real estate, investing, and other topics.
Posted on Aug 13, 2019

You know that your child’s college education is likely to cost a lot more than yours did if current trends continue. The bill for entering college in 2033 and attending a public university for four years could be, by one estimate , as much as $134,000 for tuition, room, and board.1

That’s why planning for this cost as far in advance as possible can be so important. There are a range of ways to save, but 529 college savings plans tend to be the most popular.

There are two types of 529 college savings plans that can help: 529 savings plans and 529 prepaid tuition plans.

Learn about the pros and cons of each option below. But first use our college savings calculator to see how much you might need to squirrel away.

529 savings plans

What to know: State-run 529 savings plans are designed to help make higher education more affordable. They offer a state income tax break on contributions in more than 30 states. They also offer federal and state tax breaks on account growth. What they don’t offer is a federal tax break on contributions.

They do come with another big tax break: Withdrawals used for qualified educational expenses, such as tuition, fees, books, and supplies, are often not taxed, especially at the federal level. IRS Publication 970 explains the rules in more detail.

These accounts are popular for good reason. Along with their tax benefits, 529 plans typically have a limited impact on a student’s college financial aid. Only about 5 percent of 529 plan assets, whether they’re held in the child’s name or the parent’s name, will be counted toward the family’s expected contribution to college costs.

Lifetime contribution limits to 529 plans are $235,000 to $529,000 per beneficiary, depending on the plan and the state, said Mark Kantrowitz, a nationally recognized expert on student financial aid, scholarships, and student loans. Most states have at least one plan, and because of the differences among plans, you might find that the most beneficial choice for your situation is not administered by your home state.

Options and control: Another benefit of 529 savings plans is that they allow parents to control the money if the child doesn’t attend college. Funds can be held until a later date in case the original beneficiary has a change of heart. They can also be transferred to a different beneficiary, such as a sibling, grandchild, or even a parent. 529 assets can even be used to pay for K–12 tuition. Funds not spent on undergraduate education can also be transferred to a sibling or saved for graduate school.

     Learn more: Alternatives for 529 college savings

While starting early provides more opportunity for contributions to grow through investing, it’s rarely too late to start.

Parents who have savings in a different account and want to enjoy the tax and financial aid advantages of a 529 plan may front load the plan with annual exclusion gifts. The annual gift tax exclusion — the amount of money that one person may transfer to another as a gift without incurring a gift tax — amount is $15,000 per donor per beneficiary in 2019. But with a 529 plan, individuals may contribute up to $75,000 ($150,000 for couples) per beneficiary if the contribution is treated as if it were spread over a five-year period. To avoid gift tax implications, parents may need to avoid giving other gifts to the same beneficiary for the next five years. Parents might consider working with a tax professional for guidance when making these decisions.

The age-based funds offered by many 529 savings plans allow for a set-it-and-forget-it approach to investing. The fund will invest more aggressively when the child is young and transition to a more conservative portfolio as the child approaches college age. If you’re familiar with target-date funds for retirement, the concept is similar.

Cons : You may have heard that 529 plans have some potential drawbacks, as most financial products do.

First, 529 savings plans come with different options and investment choices. One size does not fit all, so to speak. Therefore, you’ll want to do careful research or work with a trusted financial professional. Find the plan that could give you the best combination of tax benefits, high-quality investment options, and low fees.

Second, you’ll want to be mindful of the potential tax penalties. If you withdraw the money for a purpose other than qualified education costs, you may owe income tax and a 10-percent tax penalty on withdrawn earnings. Federal income tax and penalties typically do not apply to withdrawn contributions, but any state tax breaks on contributions may have to be repaid. (Learn more: 529 mistakes)

529 prepaid tuition plans

The basics: 529 prepaid tuition plans let parents pay in advance for education at a particular university or group of universities. Payment is based on current tuition rates. It could make sense to choose one of these plans if you think tuition costs will rise faster than inflation and if you want to avoid the risks associated with stock and bond investing. However, you will want to be aware of these plans’ limitations as well as their benefits.

529 prepaid tuition plans are far less popular than 529 savings plans. At the end of 2018, both types of 529 plans combined held a total of $311.1 billion in assets, according to the Investment Company Institute .2

Of that total, $288.2 billion was held in 529 savings plans. Only $22.9 billion, or about 8 percent, was held in 529 prepaid tuition plans. Their lower popularity may be attributable to their lower flexibility and availability compared with 529 savings plans.

Only 9 states offer prepaid tuition plans for public colleges and universities. Those states are Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, and Washington. Unlike 529 savings plans, you may need to be a resident of one of those states to participate in its prepaid tuition plan.

For those with private school ambitions, the Private College 529 Plan offers a prepaid tuition plan for nearly 300 private universities across the United States . Included in the program are standouts such as Stanford, MIT, Spelman, and Princeton. Not all participating schools are elite institutions. Prepaid tuition credits do not affect admission choices by member schools.

What happens if you want a refund of your prepaid tuition credits? Your options depend on the plan.

The Private College plan allows you to change the beneficiary, do a rollover to another 529 plan, or get a refund. Like 529 savings plan withdrawals, prepaid plan refunds may be subject to taxes and penalties.

With the state plans, options for redirecting or refunding prepaid tuition vary by plan, but you do have options.

Other vehicles

529s aren’t the only college savings options. The alternatives are less popular, but may be of interest to some families.

Coverdell Education Savings Accounts (ESAs): Coverdell ESAs offer the same federal tax breaks as 529 savings plans but do not offer any state tax breaks. As the account balance grows, you’ll owe state income taxes on the earnings. Also like 529 savings plans, you’ll pay a 10 percent penalty on earnings withdrawn for purposes other than education. ESAs can be used for K–12 education as well as higher education.

Besides their tax treatment, these accounts have other important differences from 529 plans. They have a low contribution limit of $2,000 per year per beneficiary. The IRS imposes an income phaseout on contributions. Also, contributions can’t be made after the beneficiary turns 18 (except for special-needs beneficiaries). And parents control the account only until the beneficiary turns 30.

UGMAs and UTMAs: Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts are sometimes used to achieve tax savings by transferring assets from a higher-taxed parent to a lower-taxed child. Unlike 529s and ESAs, they do not offer state or federal tax breaks for college. They do allow for large contributions, though it’s important to be aware of gift-tax implications. Investment options are nearly limitless, too.

While the child is a minor, the parent can use the money in the account to pay for expenses that benefit the child. The child gains full control over the account upon reaching the age of majority (18 or 21 depending on the plan and state) and may not use the money how parents wish they would.

“In general, we try to steer away from using UGMA and UTMA accounts unless there is a unique circumstance,” said Certified Financial Planner™ professional Adam Beaty of Bullogic Wealth Management near Houston. “The reason we steer away from UGMA and UTMA accounts is that they are considered the child's assets. This is problematic when trying to receive financial aid.”

Colleges expect about 20 percent of the balance in these accounts to be used toward college expenses.

However, a family that is so wealthy that they will not qualify for financial aid may gain modest tax savings from using these accounts to save money in the child’s name, Kantrowitz said.

Conclusion

Our most recent MassMutual College Planning and Savings Study revealed that only 28 percent of families who anticipate that their kids will go to college plan to use a tax-deferred savings program such as a 529 plan. Join these families and you may help put your child’s college goals within easier reach.

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NerdWallet, “Experienced Mothers to Expectant Moms: Start Saving for College Now,” April 22, 2015.

Investment Company Institute, “529 Plan Data,” December 2018.

The information provided is not written or intended as specific tax or legal advice. MassMutual and its subsidiaries, employees, and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own, and do not necessarily represent the views of MassMutual.