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Saving for College? Prepaid Tuition Plan v. College Savings Plan?

09.26.16 | TAX Chat

Section 529 plans provide a tax-advantaged way to help pay for college expenses. Here are just a few of the benefits:

  • Although contributions are not deductible for federal purposes, plan assets can grow tax-deferred or tax free if used for qualified education expenses.
  • Some states offer tax incentives for contributing in the form of deductions or credits.
  • The plans usually offer high contribution limits, and there are no income limits for contributing.
  • You can change the beneficiary or rollover the funds to another qualified plan for the same beneficiary or a different beneficiary without income tax consequences.

However, it should be noted that distributions of earnings in excess of qualified education expenses are taxed to the beneficiary and a 10% penalty is imposed. Also, a contribution to a plan on behalf of a beneficiary is treated as a gift to that beneficiary, and therefore, if the contribution plus all other gifts to the beneficiary for year exceed the annual gift tax exclusion, you may incur gift and generation-skipping tax consequences (you may be able to make an election to spread the contribution over five years for gift tax purposes). Finally, be aware of the fees charged by different 529 plan custodians.

There are two types of plans – prepaid tuition plans and savings plans. This post will address prepaid tuition plans; next week’s post will address savings plans.

Prepaid tuition plans

With this type of 529 plan, you can prepay some or all of your child’s college tuition at current tuition rates, regardless of the cost at the time your child actually attends the school. This can provide substantial savings if you invest when the child is still very young.

Most prepaid tuition plans are administered by individual states, and can generally be redeemed for only undergraduate tuition costs at in-state public colleges. However, you should check with individual private schools to find out what plans they offer. The major benefit to the prepaid tuition plan is that the portion of the tuition you pay in advance is guaranteed, no matter how the stock market performs.

Most states guarantee that the funds that you put into the plan will keep-up with tuition increases. One major downside to the prepaid tuition plan is that plans sometimes announce modifications to the benefits they will pay out if their investment returns do not meet projections. Another is that the plan doesn’t typically cover costs other than tuition, such as room and board. Finally, there’s uncertainty in how benefits will be applied if the beneficiary attends a school outside the plan’s coverage. Any unused principal can by withdrawn (some states pay a small amount of interest), but you will have lost out on all the investment appreciation.

Whether a prepaid tuition plan or a savings plan is better depends on your situation and goals. If you’d like help choosing, please contact me at HZemel@BerdonLLP.com or your Berdon advisor.

Hal Zemel, a Tax Principal at Berdon LLP, New York Accountants, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.