I’ve written in the past about the best 529 plans, but I’ve never really written an article explaining exactly what these plans are all about. In short, 529 plans are tax-advantaged savings plans that are designed to encourage people to save for future college costs. But there’s more to it than that…
In general terms, 529 plans com in two flavors: pre-paid tuition plans, and college savings plans. I’ve put together a thumbnail sketch of each type, below.
529 Pre-Paid Tuition Plans
Pre-paid tuition plans allow people to pre-pay for all or part of a future college education at today’s prices. Some of these plans allow you to buy “units” of tuition (corresponding either to a set number of credit hours, or a percentage of the tuition bill), whereas others allow you to purchase contracts for one to five years of tuition.
The advantage of these plans are that they are guaranteed to cover the future cost of education. A major disadvantage is that they are targeted toward public colleges or universities, and are typically limited to state residents. Beyond this, pre-paid tuition plans cover only tuition and mandatory fees, though some plans offer a room and board option, or let you use excess tuition credits for other expenses.
529 College Savings Plans
College savings plans allow an account holder to save and invest for future college expenses on behalf of a beneficiary. The account holder can choose amongst a number of investment options including stock and bond mutual funds, money market funds, and age-based portfolios.
These plans are similar to Roth IRAs in that there are no federal income tax benefits, but withdrawals are tax free as long as you use them to cover qualified expenses. Qualified expenses include tuition, fees, room and board, textbooks, and computers (if required).
The contribution limits on these plans are very high, generally in excess of $200k total, and they are also more flexible than pre-paid plans in that you’re not locked into a particular school (or even state). The primary disadvantage is that there is no guarantee that your investments will cover the future cost of a college education.