State Savings Plans vs. Prepaid Tuition Plans

Section 529 plans are becoming popular college savings vehicles. Due to the demand for them, almost all states now operate at least one type of 529 plan (either a prepaid tuition plan or a state savings plan), and an increasing number are offering both. To choose the type of 529 plan that's right for you, it's important to understand how prepaid tuition plans and state savings plans work and the differences between them.

How does each plan work?

As 529 plans, both state savings plans and prepaid tuition plans offer significant federal tax advantages. Funds in each type of plan grow tax deferred, and withdrawals from either plan used for the beneficiary's qualified education expenses are completely income tax free at the federal level. But despite these shared tax advantages, state savings plans and prepaid tuition plans are different creatures.

A state savings plan lets you build an education fund within an individual investment account. Money you contribute is invested in one or more specific investment portfolios. Each portfolio consists of a mix of investments (typically mutual funds) that are chosen and managed exclusively by the plan's designated money manager. You generally pick your investment portfolio at the time you open an account, or else one is automatically chosen for you. Your investment return is not guaranteed.  

In contrast, a prepaid tuition plan lets you purchase tuition now for use in the future. There are generally two types of prepaid tuition plans: contract plans and unit plans. A contract plan (sometimes known as a guaranteed interest plan) promises to cover a predetermined amount of tuition expenses in the future, in exchange for your lump sum or periodic contributions.

With a unit plan, you purchase a certain percentage of units or credits and the plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future. For example, assume that 100 tuition credits are required to fund one year's worth of tuition at State University today. You purchase 100 credits today for $8,000. The result is that when your child starts college at State University in 12 years, your $8,000 will theoretically pay the entire first year of tuition, even though tuition costs may have risen to $20,000 per year by then. 

Note: Due to the recent convergence of surging college costs and a stagnant economy, several state prepaid tuition plans have projected actuarial deficits, prompting plan administrators to force participants to withdraw from the plan or accept future benefits that might be less than what was promised. 

Who can offer these plans?

At one time, only states could offer prepaid tuition plans and state savings plans. (In practice, the states designate an agent, usually an experienced financial institution, to manage and administer their plans). But colleges and universities can now offer their own prepaid tuition plans. These plans are sometimes referred to as private prepaid tuition plans, and the beneficiary is limited to attending the college(s) in the plan. However, the remainder of this discussion refers to state-sponsored prepaid tuition plans.

How are your contributions invested with each type of plan?

State savings plans and prepaid tuition plans differ on the way your contributions are invested. With a prepaid tuition plan, there are no individual investment accounts. Instead, your contributions go into a general fund, and the plan's money manager is solely responsible for investing the pooled money to meet the plan's future obligations to its participants. Your only concern is with the predetermined amount of tuition that the plan has agreed to cover in the future, or the percentage of tuition costs that the units or credits you've just purchased will eventually cover.  

With a state savings plan, your contributions are held in an individual investment account in one or more specific investment portfolios. The trend is for plans to let you choose your investment portfolio at the time you open an account. Typically, plans offer a variety of options--from aggressive to conservative--so you can choose a portfolio that matches your risk tolerance, time horizon, and other factors. But remember, the plan's money manager handles the underlying investment mix in each portfolio on a day-to-day basis--you have no say in this process.     

Some states may not let you choose your investment portfolio when you join the plan. Instead, they will automatically assign you a portfolio based on the beneficiary's age (called an age-based portfolio). With an age-based portfolio, the underlying asset mix consists of more aggressive investments when the beneficiary is young (such as stock mutual funds) and then is gradually and automatically shifted to less volatile investments (like bond funds and money market funds) as the beneficiary nears college. The idea is to take advantage of the potential for higher returns (with the accompanying risk) when the beneficiary is young, and then preserve principal as the beneficiary approaches college age.

Once you've settled on an investment portfolio for your state savings plan account, you have limited opportunities to change it if you're not happy with its investment performance. Under IRS rules, plans are authorized, but not required, to let you change your investment portfolio once per calendar year or at any time you change the beneficiary. Some plans may also allow you to direct future contributions to a new portfolio. Such investment flexibility can make one plan stand out among others, so it's always a good idea to check the specific investment rules of any plan you're considering.  

You also have another option guaranteed by federal law. You can roll over the funds in your existing state saving plan account to another 529 plan (state savings plan or prepaid tuition plan) once every 12 months without penalty. The beneficiary stays the same. 

In your effort to pick a suitable portfolio, keep in mind that no investment in a state savings plan is guaranteed--you could lose money that you've contributed. That's why it's important to investigate the reputation and overall investment performance of the institution that manages the state savings plan, as well as the performance history of individual portfolios in the plan.

Are there any restrictions on joining either type of plan or accessing the funds?

Yes. Most state savings plans are open to citizens of every state. This means you can shop around for the plan that offers the combination of features you want. (But keep in mind that if you join another state's state savings plan, you'll generally be entitled only to the state tax benefits offered by your state.) Beyond that, you can open a state savings plan at any time of the year, and the account can generally remain open indefinitely. This gives you flexibility if your child decides to postpone his or her education.

By contrast, most prepaid tuition plans are limited to state residents only. And once you open an account, all tuition credits generally must be used by the time your child turns 30, and all withdrawals completed within 10 years from the time your child starts college. Also, at some point before your child starts college, you (the account owner) are required to inform the plan administrator when you expect to start redeeming credits. Finally, some prepaid tuition plans let you join only during specific enrollment periods.

What education expenses are covered by each plan?

State savings plans give you more flexibility in paying your beneficiary's education expenses. Funds in a state savings plan account can be used to pay for tuition, books, equipment, fees, other costs, and room and board (assuming the beneficiary is enrolled at least half-time) at any college accredited by the U.S. Department of Education. This includes undergraduate colleges, graduate and professional schools, two-year colleges, technical and trade schools, as well as some foreign colleges and universities.

By contrast, prepaid tuition plans are typically designed to pay only for undergraduate tuition costs at in-state public colleges--other expenses like room and board, books, and graduate school usually aren't covered. However, such restrictions are imposed by the individual prepaid tuition plans themselves, because Section 529 of the Internal Revenue Code allows a broader interpretation of qualified education expenses. Make sure you understand exactly what education expenses your prepaid tuition plan covers, as well as the tuition equivalent you'll receive if your child attends a private or out-of-state college.

What are the fees and expenses associated with each type of plan?

State savings plans, like other types of managed accounts such as mutual funds and annuities, are managed by professional money managers who pass along their investment expenses to account owners. In addition, the plan manager will charge you a fee for administering your account. Both of these fees are usually equal to a percentage of your total account value. Some state savings plans may also tack on a flat annual maintenance fee, though this may be waived if you sign up for automatic payroll deduction or direct debiting of your checking account. Because fees and expenses vary among plans and can affect your account's total return, examine them carefully.

Prepaid tuition plans typically charge a flat enrollment fee at the time you open your account, but generally there are no ongoing charges. However, you may be assessed fees for late payment, returned checks, changing the beneficiary, changing the beneficiary's enrollment date, document replacement, or other administrative matters.  

You may want to ask the following questions to help you better compare the fees of state savings plans vs. prepaid tuition plans:

·        Is there an application fee, beneficiary substitution fee, or account owner substitution fee?

·        What other fees and costs are charged, and what are the amounts?

·        Will my fees be less if I contribute through payroll deduction or automatic deduction from my checking account?

·        Is there a fee to do a rollover to another state's plan?

·        Will I be penalized if I move my account out of the plan within a short time after I open the account? How short a time?

·        Is there a fee if I terminate the account?

·        Do I pay the fees separately, or is the fee deducted from my account?

What is the income tax treatment of withdrawals from each plan?

Withdrawals from a state savings plan or a prepaid tuition plan used to pay the beneficiary's qualified education expenses (as defined by the individual plan within federal guidelines) are completely income tax free at the federal level. And if your state exempts such withdrawals from income tax too, it does so for both state savings plans and prepaid tuition plans.   

A withdrawal not used for the beneficiary's qualified education expenses is called a nonqualified withdrawal. If you make a nonqualified withdrawal from a state savings plan account or a unit type of prepaid tuition plan (where you purchase tuition credits), a 10 percent federal penalty will apply on the earnings portion of the withdrawal (a state penalty may also apply). What's more, the earnings portion of the withdrawal will be subject to federal and state income tax.

A nonqualified withdrawal isn't possible if you have a contract type of prepaid tuition plan. If you want to get your money out of this type of plan, your only choice is to cancel your contract and have your money refunded. (If you do cancel, you may only get back your actual contributions, with no interest or earnings included. Other plans will refund your principal plus a low rate of interest, which is then taxable at regular income tax rates.)

Note: This discussion refers to provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, which made qualified withdrawals from a 529 plan tax free at the federal level. These provisions are scheduled to expire on December 31, 2010. Unless Congress extends the law, after December 31, 2010 the federal tax treatment of 529 plans will revert to its status prior to January 1, 2002.

What impact does each type of plan have on financial aid?

State savings plans and prepaid tuition plans are treated differently for purposes of federal financial aid, but generally are treated the same for purposes of institutional aid (aid distributed by colleges from their own endowments).

Under federal financial aid rules, assets are classified either as a parent's asset or a child's asset. This classification determines the assessment rate of the asset. The assessment rate is the portion of the asset that you are expected to use for the current year's college expenses.  (Income is also classified this way.)

A state savings plan account is classified as a parental asset and assessed at a rate of 5.6 percent (compare this to a 35 percent assessment rate on a child's asset). The result is a reduction in your child's federal financial aid award by 5.6 percent of the value of your state savings plan account. Note: If a grandparent or some other person besides the parent owns the state savings plan account, it isn't considered a parental asset and has no effect on financial aid.

Distributions (withdrawals) from a state savings plan that are used to pay the beneficiary's qualified education expenses aren't classified as either parent or student income.

By contrast, a prepaid tuition plan account is not considered a parent's asset or a child's asset under federal financial aid rules.  But distributions are counted.  Any distributions from a prepaid tuition plan reduce the college's cost of attendance, and thus reduce federal financial aid dollar-for-dollar. In other words, every dollar that flows out of your prepaid tuition plan account will reduce your child's financial aid award by one dollar.

As for institutional aid, most colleges treat state savings plans and prepaid tuition plans as parental assets (with a 5.6 percent assessment rate) and withdrawals as student income (assessed at 50 percent).