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What makes prepaid plans different from 529 plans?
There are two main types of Section 529 plans: prepaid and savings. But it's not always easy to put a programme in one category or another because some plans have features that are common to both prepaid and savings programmes.
In some situations, they work like prepared programmes, and in other situations, they work like savings programmes. In some states, prepaid and savings programmes are combined into one package and sold to the public as one programme with different choices. If your state has a funded programme, the first thing you should do is check to see if you can join. Notably, Alabama, Colorado, Kentucky, Ohio, South Carolina, Texas, and West Virginia have either temporarily or permanently stopped people from signing up for their prepaid programmes. Other states might do the same if rising tuition costs make it harder for programmes to stay financially stable.
How to Understand Prepaid 529 Plans
In a prepaid programme, you buy tuition credits or awards that let the recipient get college costs waived or paid for in the future. In essence, you are paying for school for the future now. The price you pay now doesn't have to match the cost of school right now, but it is still taken into account when prepaid programme prices are set.
There are three different kinds of prepaid programmes, with the "contract" programme run by the government being the most popular. In exchange for a cash payment up front or a number of cash payments, the programme promises to pay for future tuition and required fees at public colleges, universities, or community colleges in the state.
The length of the contract can be anywhere from one semester to five years, based on the packages offered by the programme and how much tuition you want to buy. If the recipient goes to a private or out-of-state school, the programme will use a set method to figure out how much the contract is worth and pay more than that amount.
A combination prepaid/savings programme, sometimes called the "unit" programme, is another type of prepaid programme that is also backed by the government. It includes buying tuition units or credits that are equal to a small portion (like 1%) of the average annual tuition and required fees at public schools in the state. The value of these units goes up or down every year based on how much the average in-state tuition and fees go up or down. In the future, they can be used to pay for tuition, fees, and, in most cases, other qualified costs like room and board, books, supplies, and equipment.
It's still up for debate whether to call the unit programme prepaid or savings, since both are treated the same when figuring out if a student is eligible for federal financial help. In 2000, Pennsylvania changed its unit-type prepaid programme and called it a "guaranteed savings" programme. At the time, prepaid programmes had a lot going against them in the federal formula, so Pennsylvania did this to help its members.
The third type of prepaid programme, called a "voucher" programme, is one in which one or more educational schools participate on their own. In exchange for your donation, you will get a certificate that can be used to pay a certain portion of tuition and required fees at any of the participating schools. At the time of contribution, the amounts are set. For example, a $5,000 donation could cover 50% of one year's tuition and fees at College A and 30% at College B.
If your child goes to one of the schools listed, the tuition bill goes down by the amount shown. If your child goes to a college that doesn't take part in the programme or decides not to go to college at all, you can ask for a return of your payments, which will be adjusted for interest and other things that are explained in the programme papers.
The U.Plan in Massachusetts was the first programme of its kind. It was made up of 80 business and public organisations. Even though it's not a real 529 plan, people who take part don't have to pay federal or Massachusetts income tax because Massachusetts general obligation bonds were issued. The Private College 529 Plan, which was started in the autumn of 2003 and pays for private college, is another programme that works like a pure coupon.
Think of a contract programme like a futures contract, a unit programme like an index fund (where the index is the average tuition at certain schools), and a voucher programme like a discount ticket to better understand the three types of prepaid programmes. All three types depend on the programme trust fund, which is made up of participant payments or contributions, to create enough investment returns to cover future tuition payments and unit redemptions, or in some cases, the school's liability for these costs.
Unravelling 529 Savings Programmes
A 529 savings plan is a more common tax-deferred investment, and it is similar to a Roth IRA in many ways. People put money into a trust fund, which is then used to invest in mutual funds and other types of financial products. The main goal is for your account to grow in value over time, hopefully at a faster rate than college costs. Before Congress passed Section 529 in 1996, some states had programmes where you could pay for college ahead of time. Only Kentucky had a pure savings programme. Most new 529 plans have been savings programmes since 1996.
Several things are causing this trend. Savings programmes have the potential for higher investment returns than either prepaid savings accounts or guaranteed savings accounts. This is because they usually invest in equity and bond mutual funds, which have generally done better than increases in college costs.
Also, savings programmes are easier and cheaper for states to run, especially when an outside company manages the investments and does a lot of the promotion and running of the programme as well. Some states have recently changed their programmes or started new ones where a fee charged to the programme fund is split between the programme manager and the government. This makes the programme a way for the state to make money.
How Prepaid and Savings Programmes Are Different
When figuring out how good a college savings plan is, the main thing to look at is how it handles investments. We all want our capital to do well, after all. In the past, stocks have done better than many other investments over long periods of time, with some types of popular stocks doing better than others.
Stocks, on the other hand, have a bigger risk than most other investments. Most 529 plans, no matter what kind, use professional investment managers to get the best possible returns while staying within a certain amount of risk. In a savings programme, the management of investments is done directly with the money in the account of each member. In a prepaid guaranteed savings programme, on the other hand, the fund is managed to make sure it can pay for future fees or unit redemptions.
Participants in a prepaid programme don't have a say in how the state chooses financial managers, so they have to trust the program's staff. Prepaid and guaranteed savings programmes offer the benefit of keeping up with inflation in college costs, no matter how much those costs go up. Savings programmes offer the benefit of having an endless amount of upside investment potential. A saver who doesn't mind taking risks may be more interested in a savings programme, while a saver who doesn't like taking risks may be more interested in a prepaid or sure savings programme.
Here are some of the biggest differences between prepaid and savings programmes:
Ownership and Prices: When you put money into a savings programme, you own a piece of the programme fund. Prepaid programmes, on the other hand, involve buying the promise that the programme will give you certain benefits in the future. The programme works out the price of the promise and any requests for a return.
Enrollment Periods: Most prepaid programmes have set times when you can sign up and buy prepaid contracts. Savings programmes, on the other hand, don't have specific times when you can join and can accept new accounts and money at any time.
Residency requirements: Most prepaid programmes require either the account owner or the account user to meet state residency requirements. Most savings programmes, on the other hand, are open to residents of any state.
Duration of Contracts: Most prepaid contracts only last for a certain amount of time, while savings programmes with a living beneficiary can stay open forever.
Qualified Expenses: Most prepaid programmes only cover tuition and mandatory fees for undergraduates, but savings programmes can usually be used for any qualified higher education cost.
Flexibility for Out-of-State Schools: All 529 plans let you take money out to pay for college or university out of state. But prepaid contracts are generally made for public schools in the same state, which could limit the benefits for schools in other states.
Calculating Investment Return: With prepaid programmes, the investment return often relies on the school attended and the number of credit hours taken. With savings programmes, the investment return is more predictable.
Payment Process: Prepaid programmes send payments straight to the school based on upcoming tuition bills. Savings programmes, on the other hand, let you take out cash without a lot of paperwork.
Transaction Fees: There may be more transaction fees for prepaid cards than for credit cards.
Minimum Purchase: Some prepaid programmes require you to buy at least one semester's worth of fees up front, but you can pay for it over time.
Stability: Prepaid programmes use actuarial estimates to make sure they are financially stable, but savings programmes usually don't need these kinds of guarantees.
In conclusion, as the lines between prepaid and savings programmes continue to blur, it seems possible that, over time, the best parts of each could be combined into a single programme. By knowing how each plan is different and what its benefits are, families can make better choices about how to pay for their children's future education.
