According to the College Board, the most recently published figures of the average annual cost of tuition and fees were…
- $10,950 for public in-state students.
- $28,620 for public out-of-state students.
- $39,400 for private university.
Thankfully, much like tax-advantaged accounts designed to help us save for retirement, there are tax-advantaged accounts designed to help families set aside funds for future college costs – 529 plans. There are two types of tax-advantaged college savings programs: college savings plans and pre-paid tuition, the former being the most popular.
The attraction of 529 college savings programs is that both provide for investment earnings to grow on a tax-deferred basis. In addition, funds used to pay for qualified education expenses may be withdrawn free of tax. That makes investment growth switch from tax-deferred to tax-free – woohoo! Your state may also offer a tax deduction for 529 plan contributions. In MA, individuals are able to deduct up to $1,000 and couples $2,000 when contributing to the Fidelity MEFA plan. Given MA has a state tax of about 5%, this doesn’t work out to a huge savings – but still worth mentioning.
Prepaid Tuition vs. College Savings Plans
One type of 529 program is the prepaid tuition plan, which allows you to lock in tuition rates at eligible state colleges and universities.
Most are sponsored by state governments and allow account holders to “purchase” tuition at today’s rates and “redeem” the credits in the future when your child is going to college. In effect, the state is absorbing tuition increases during the years in between.
Example from MEFA: Let’s say you contribute $1,500 to your U.Plan to cover 10% of a year of mandatory fees and tuition now at a given school ($15,000). If the tuition and mandatory fees increase to $25,000 over the life of your U.Plan, that Tuition Certificate will still cover 10%, or $2,500, of tuition and mandatory fees at that school, meaning you saved $1,000.
Pre-paid tuition plans allow you to pay for tuition in one payment today or through installments, but generally don’t cover expenses such as room and board. Your contributions are then pooled with other plan participants and invested by the state, then transferred to the appropriate school when your child starts college. But since the state is managing the investments, you have no investment options (but this also makes managing the account less complicated for the investor).
In contrast, college savings plan typically offer several investment options, at varying levels of risk, depending on how close the child is to college. Plus, college savings plans allow students to attend any accredited post-secondary school, public or private, irrespective of the state where you live or where the college is located. This factor alone is usually the straw that sways families to choose a savings plan vs a pre-paid plan.
In addition, although the investments are managed by a state-designated professional money manager – typically through mutual funds – and are allocated to mutual funds based on the age of your child (the beneficiary), you generally get to determine which investment is appropriate for you, based on your risk tolerance and other factors.
The investment objectives of the mutual funds are also what most people are familiar with: equity mutual funds, fixed-income mutual funds and money market mutual funds or age-based mutual funds that shift the allocation among stocks, bonds and cash depending on the age of your child.
The following chart was copied from the Securities and Exchange Commission and outlines many of the major differences between prepaid tuition plans and college savings plans:
Which is Right for You?
Your own financial situation will determine whether a prepaid tuition plan or college savings plan is the preferred vehicle to help someone through college. Part of this determination includes the effect that either will have on your student’s financial aid eligibility and your own estate planning.
The decision may come down to availability as well. There are not that many states providing prepaid tuition plans and accepting new applications. While this list is always changing, currently 10 states seem to be accepting new applicants: Florida, Illinois, Maryland, Massachusetts, Michigan, Nevada, Pennsylvania, Texas, Virginia, and Washington. I’m obviously largely familiar with the Massachusetts option, MEFA UPlan, which is run through Fidelity. They are currently working with 70 schools within the state. That said, a handful of years ago the program included 80 schools, so I wonder the trajectory of the program in terms of it having enough variety to meet your child’s education goals.
Also worth mentioning, pre-paid options mean relying on a state to fulfill a financial guarantee, especially with shrinking state budgets. New Mexico, for example, terminated its program altogether; Colorado is no longer open to new account holders; and Alabama froze its payouts at 2010 levels.
Like the tax savings… but worried about the flexibility of a 529 Plan?
As mentioned above, the savings plan has more flexibility than pre-paid due to the openness of college choices. But beyond that, clients often ask me what happens if they don’t use all the funds. Us parents are always crossing our fingers for a full-ride scholarship! There are certainly options in this regard.
- First, each 529 account will list a beneficiary, but this selection is not set in stone. If one child doesn’t use their full balance, it can easily be re-designated to another child or relative.
- Accounts can also be used for post-graduate education, such as an MBA, law school, or medical school.
- If scholarship is a factor, you’re able to take out an equal amount from the 529 without penalty. You’d simply pay the tax on the gains, which would be the case had it been invested in a brokerage account – fair enough.
- The caveat here is the distribution needs to be done in the year the scholarship was granted. Don’t wait around until graduation to clear out the account by submitting proof of past scholarship, a mistake I’ve heard plenty of people make.
- The recent SECURE Act 2.0 created an interesting provision allowing 529 balances to be rolled over to a Roth IRA. If your child did not use their full balance, once the account has been open for 15 years you’d be able to make rollover Roth IRA contributions for the beneficiary of the 529 (up to the annual max, currently $6,000). The lifetime maximum you could rollover from the 529 is $35,000. For instance, if you had $20,000 remaining in 529 with no other child to designate the balance to, you’d be able to contribute the annual max over a period of 4 years ($6,000 + $6,000 + $6,000 + $2,000= $20,000) once the account has been open for a total of 15 years. This rollover counts toward your Roth contribution for the year.
- Lastly, you may just want to keep the account as-is for future grandchildren to give your kids a leg-up on college savings.