Should You Save for Your Child's College Using a 529 Prepaid Tuition Plan?

Investment on knowledge is the best form of investment, and savings as they say, is the prerequisite of investment. With college prices already soaring and expected to further sky rocket in the future, the best time to save is now. As per estimations by financial experts, for today’s newborn, the cost of college would be about $75,000 yearly for public school and a staggering $148,000 a year for a private one. If these figures do come true, parents will have to start saving for their kids well before their birth.

Education funds can seem tricky and sometimes even intimidating, but a common way to save and invest for your child’s future education is through a 529 plan.

What is a 529 plan?

Qualified Training Program, also known as section 529 plans, is named after Section 529 of the Internal Revenue Code. These are state-sponsored plans that are tax-deferred for educational purposes. But if you withdraw money from it for any other reason, you are liable to pay tax as well as an additional 10% penalty on the earnings.

Recently, a group of private colleges and universities launched their Independent 529 plan. However, primarily there are only two provisions to a 529 plan – a prepaid tuition plan and a college savings plan. Let’s talk about the former.

529 prepaid tuition plan

A 529 prepaid tuition plan allows you to pay your future college-cost in advance. It allows you to lock-in tuition amounts at current rates, to cover higher-education expenses when your child goes to college in the future. Though a 529 plan is a federal provision, it is administered by state governments. In simple terms, if you pick a prepaid tuition plan, the semester’s fee today would be equivalent to a semester’s fee when your child enters college. The key advantage of the plan is that it tends to act as a hedge against economic downturns and acts as a buffer from probable future inflation.

Like any other financial product, prepaid tuition plans are not for everyone. Each state’s plan is different, and you should analyze the pros and cons before making such a huge commitment.

Advantages of 529 plans:

Most benefits of the prepaid plan are same as that of a 529 savings account. On paper, a prepaid tuition plan appears to be a fantastic product. Here are some key points to note:

It guarantees to keep pace with inflation and there are generally no income or age limitations.
The principal sum grows tax-deferred and withdrawals are not taxed, as long as, the funds are spent towards qualified higher education expenses.
Like a 529 savings plan, a prepaid tuition plan also has a very high contribution limit. The maximum amount which you can accumulate in a single account would depend on the state that is sponsoring your plan.
The donor has full control of the account and the beneficiary, apart from a few exceptions is just an audience.
These investments are not counted as part of the donor’s gross estate for estate tax purposes and can be used as a tool for estate planning.

What makes it a more lucrative option is the simplicity it offers. The donor just has to complete the form and the ongoing investment is handled by the plan and not by the donor.

Although there exists a state-residency criterion, wherein the available benefits can be availed only in that particular state-sponsored college, but all is not lost if your child decides to go to school out of state. The principal is refunded but the interest is retained by the state in most cases. One way to avoid this is by transferring the fund to a child’s sibling who would be attending the school in the same state (although in a few states, there may be age restrictions which could limit an older sibling from availing the benefits). Another benefit that is often ignored is that since your child would be studying in the same state close to your home, the overall expenses on college are likely to be minimal.

Disadvantages 529 plans:

The plan does come with some shortcomings. Such as:

Residency criteria: A major disadvantage is that prepaid plans do not cover many expenses, and in most states, only the cost of tuition and fees comes under their ambit. Unlike 529 savings plan, rooms and boarding expenses are also not covered under the plan. Most states, except for Massachusetts, require you or your child to be a resident of the state where you apply, this may limit the educational choices for your child in the future.
Less control: Being a contractual installment, parents have very less control over contributions which can take a toll on your finances during a rough patch.
Withdrawal woes: Withdrawal limit can also play a huge hurdle. A non-qualified withdrawal can result in a 10% federal penalty on your earnings and imply federal and state tax implications.
Dependence on state funding: If increasing tuition rates outpace the return on your investment, the state may be unable to pay the difference. Such a scenario can be a huge roadblock for your goals.
Limited enrollment periods: You can only apply once a year. If you don’t plan it well or miss out on the deadline, you can end up losing an entire year.

Alternatives to 529 prepaid plan:

529 savings plan: One of the best alternatives to a prepaid plan is the 529 savings plan. It covers more expenses and provides greater flexibility with withdrawals.
Brokerage accounts: Apart from giving you access to buy or sell from your investment, some brokerage firms also offer certain perks such as bonuses.
Custodial accounts: These place no restrictions on the usage of your funds as long as they benefit the child.
Coverdell Education Savings Accounts (ESAs): Although a lot similar to a 529 plan, an ESA is not just limited to college expenses.
Roth IRA: Usually used as a retirement account, a Roth IRA can be used to cover many other expenses as it lets you access your contributions penalty-free.
Cash-value life insurance: These insurance policies let you take out a loan against the cash value at a very low-interest rate.

To sum it up

No matter what you choose, always exercise caution and read the fine print of a policy before making a decision. You must also evaluate your financial situation before selecting a college savings program. Investing in a 529 prepaid plan is a good option if your child attends an in-state eligible school, so try to discuss these options with your kids along the way. And if you do choose a prepaid plan, avoid pre-mature cancellations. Revoking the contract won’t harm the principal amount but can lead to a loss in growth.

If you are still unsure if the 529 plan is the right investment for your child’s future, consult a financial advisor for suggestions on the best suited plan for you and your child.