To help defray those costs many parents, grandparents and guardians have turned to 529 plans. Thanks to their many benefits, assets in the plans have exploded.
But not every 529 plan is the same, and there are two broad types that function similarly yet offer different outcomes.. Choosing the correct one for your beneficiaries’ college savings is critical in order to meet your goals. Read on to learn about both varieties and how to choose between the two.
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Two Main 529 Flavors
All in all, 529 plans are a wonderful way for parents (and others) to save for a child’s education needs. But in that saving, investors have two main flavors to choose from, with each offering different risks/rewards and outcomes based on a variety of plans chosen.
529 Savings Plans
When investors think about the odds of 529 plans, they are thinking about 529 savings plans. As the most common type, these state-sponsored plans allow investors to contribute money that is invested in a variety of ways. The master portfolios can include mutual funds and ETFs as well as bank deposits and CDs.
While plans vary by state and the underlying plan sponsor, most have so-called target-date options that adjust their holdings and become more conservative as the beneficiary gets closer to college age. In addition, many offer investors the chance to build custom portfolios of various asset classes to meet their goals. Savings plans can offer both active managed funds and indexed portfolios, or a combination of both. Costs vary by plan and the underlying asset class/fund chosen.
Want to learn more about mutual funds? Check out our mutual fund screener on MutualFunds.com to explore funds that meet your specific investment criteria.
The benefit to using savings plans is that investing – especially in stocks – has typically been the place to get higher returns over the long haul. This can potentially help defray more of the cost of college if investors start early enough. However, the risk is that the market could perform poorly during the savings period and you could end up with less money than when you started. So, having a properly diversified basket of assets is critical to reduce portfolio volatility, which may require more hand holding than investors want to do.
529 Prepaid Tuition Plans
Offered by only 12 states is a more conservative option called prepaid tuition plans. Essentially, these plans allow investors to buy future tuition prices with today’s dollars. If the price of college tuition at a state institution rises by 16%, the amount of prepaid tuition will increase to cover that cost. Prepaid tuition plans are guaranteed by the financial-backing power of each state. So, they can be thought of as a very conservative option.
The win is that tuition has typically increased faster than rates of inflation. Prepaid plans will often outperform other conservative options – such as money-market funds, CDs and bank deposits – found inside 529 savings plans. This makes them a good choice for risk-averse investors or those with students attending college within just a few years.
However, there are some drawbacks to these plans. For one thing, you must be a resident of the sponsoring state and the student must attend a state university in the sponsoring state to get the maximum benefits from the plan. And while you can withdraw and use prepaid 529 plans for other schools, it can get complicated as some states only allow a one lump sum withdrawal under that scenario. Additionally, the guaranteed rate of gains is for specific in-state schools. That rate may not be enough if your child chooses to attend a private school or out-of-state college.
Check out our state plans section here to learn more about the rules and regulations pertaining to each U.S. state.
Finally, most prepaid plans only cover tuition for undergraduate study. Other college expenses such as room and board, healthcare costs, lab fees, and books are not covered. However, some do include graduate study and other fees. But each plan is different. The last kicker is that prepaid plans can’t be currently used for K-12 private school expenses.
In the end, the difference between the two plans comes down to risk/return and flexibility. Savings plans offer a lot of flexibility but come with market risk. Prepaid tuition plans are just the opposite. You get a guaranteed rate of return, but you need to make sure your student is willing to go to an in-state school of the sponsoring state to get the most bang for your buck.
The Bottom Line
Be sure to check out our 529 Insights section here to learn more about 529 plans.