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Understanding the two types of 529 plans

Posted by Andrew Chan  June 11, 2012 02:00 PM

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Is there more than one type of 529 plan and if so what are the differences?

529 plans have grown to be one of the best ways to save for college since they were created in 1996 by Congress. They are commonly referred to as "529 plans" because of Section 529 of the Internal Revenue Code that governs their operation.

A 529 plan is a college savings vehicle that has federal tax advantages. There are two general types of 529 plans: college savings plans and prepaid tuition plans. Although the two types of plans share the same federal tax advantages, there are important differences between them.

College Savings Plans

College savings plans let you save money for college in an individual investment account. These plans are run by the states, which typically designate an experienced financial institution to manage their plan. College savings plans typically offer a couple of methods to invest the money in your plan including age-based portfolios and static portfolios. Age-based portfolios are ones where your money is invested more aggressively when the beneficiary is young and gradually becomes more conservative as the beneficiary approaches college. Static portfolios, on the other hand, allow you to direct your 529 plan contributions to one or more portfolios where the asset allocation in each portfolio remains the same over time. These static portfolios usually range from aggressive to conservative, so you can match your risk tolerance.

Prepaid tuition plans

Prepaid tuition plans may be sponsored by states (on behalf of public colleges) or by private colleges. A prepaid tuition plan lets you prepay tuition expenses now for use in the future. The plan's money manager pools your contributions with those from other investors into one general fund. The fund assets are then invested to meet the plan's future obligations.

The most common type of prepaid tuition plan is a contract plan. A contract plan allows you to exchange your up-front cash payment (or series of payments) for the plan’s promise to cover a predetermined amount of future tuition expenses at a particular college in the plan. Contract plans typically have a predetermined formula to figure out how much in future tuition expenses they will cover based on the amount that you prepay. These formulas typically pay a higher amount if the beneficiary goes to one of the colleges in the plan.

The other type of prepaid tuition plan is a unit plan. Under this type of plan, you purchase units or credits that represent a percentage of the average yearly tuition costs at the plan's participating colleges. Instead of having a predetermined value, these units or credits fluctuate in value each year according to the average tuition increases for that year. You then redeem your units or credits in the future to pay tuition costs; many plans also let you use them for room and board, books, and other supplies.

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