What are 529 plans?

Section 529 plans are popular college savings vehicles. Due to the demand for them, nearly every state now operates at least one type of 529 plan (either a prepaid tuition plan or a college savings plan), and an increasing number are offering both. To choose the type of 529 plan that's right for you, it's important to understand how prepaid tuition plans and college savings plans work and the differences between them.

How does each plan work?

As 529 plans, both college savings plans and prepaid tuition plans offer significant federal tax advantages. Funds in each type of plan grow tax deferred, and withdrawals from either plan used for the beneficiary's qualified education expenses are completely income tax free at the federal level. But despite these shared tax advantages, college savings plans and prepaid tuition plans are different creatures.

A college savings plan lets you build an education fund within an individual investment account. Money you contribute is invested in one or more specific investment portfolios. Each portfolio consists of a mix of investments (typically mutual funds) that are chosen and managed exclusively by the plan's designated money manager. You generally pick your investment portfolio at the time you open an account, or else one is automatically chosen for you. Your investment return is not guaranteed.

In contrast, a prepaid tuition plan lets you purchase tuition now for use in the future. There are generally two types of prepaid tuition plans: contract plans and unit plans. A contract plan (sometimes known as a guaranteed interest plan) promises to cover a predetermined amount of tuition expenses in the future, in exchange for your lump sum or periodic contributions.

With a unit plan, you purchase a certain percentage of units or credits and the plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future. For example, assume that 100 tuition credits are required to fund one year's worth of tuition at State University today. You purchase 100 credits today for $8,000. The result is that when your child starts college at State University in 12 years, your $8,000 will theoretically pay the entire first year of tuition, even though tuition costs may have risen to $20,000 per year by then.