State-Sponsored College Savings Plans
Kiplinger.comState-sponsored college savings plans (also known as 529 plans) come in two varieties, and the differences are important.
Prepaid-tuition plans guarantee participants that if they pay the price of tuition today -- in a lump sum or in monthly installments -- the state will cover the cost of tuition at state colleges and universities when their child is ready to attend years from now.
College savings plans are, in effect, state-sponsored investment accounts. Money is invested by the state, and participants share in the earnings of the account.
Both kinds of plans offer significant tax advantages. They let your savings grow tax-deferred and escape tax altogether if you use the money for qualified educational expenses, such as tuition, fees, books, and room and board. If your child takes a pass on higher ed, you can transfer the funds to another family member and preserve the tax benefits. Or you can withdraw the money yourself and pay income tax and a 10% penalty on the earnings. And 31 states plus the District of Columbia offer their residents tax write-offs for 529 contributions.
Beyond that, the plans are quite different.
Prepaid-tuition plans pay a rate of return equal to the inflation rate at public colleges and universities in your state. That can be attractive when tuition inflation is running at 10% or so. It's a lot less appealing when the rate is 5%. The main attraction here is the guarantee that college bills will be covered.
College savings plans. Most states let you choose between accounts that you can invest in directly and portfolios that you can purchase only through advisers or brokers. More than half of 529 investors buy broker-sold plans, which carry sales charges and offer more investment options. But you can find an adequate selection in a direct-sold plan -- and the lower expenses mean that more of your money will go toward building your college kitty (see Kiplinger's favorite 529 plans).
If you don't like the preset choices in your 529, you can mix and match options to strike the right balance between stocks and bonds. But most 529 investors go with one of the ready-made portfolios. Once you've settled on a mix, you'll have to stick with it, at least for a while. You can change your investment selections only once a year.
The rate of return on college savings plans will depend on how well the investments in your account perform. There is usually no guarantee, meaning you could actually lose money.
You can shop around for the best plan, because 49 states and the District of Columbia offer plans that are open to any U.S. resident. (Wyoming has adopted the Colorado plan as its own, and Washington offers only a prepaid plan.)
Money in a college savings plan can be used at any accredited college in the country. Prepaid-tuition plans are sometimes less flexible. You may pay a penalty for using the money at a school not covered by the plan.
Impact on financial aid. The money in a prepaid-tuition plan reduces your calculated need dollar for dollar. College savings plans, on the other hand, are counted just like any other investment, meaning your need will be reduced by 5.6% of the balance if included in your assets.