Prepaid Tuition Plan vs. 529 Plan: Which Is Best?

The main difference between a prepaid tuition plan and 529 plan is that prepaid tuition plans allow you to lock in tuition credits at today's prices.

Prepaid tuition plans and 529 college savings plans are specialized savings accounts used for future college costs. Prepaid tuition plans act like defined benefit plans, while 529 plans act like defined contribution plans.

There are other significant similarities and differences between them. Get the details for each to figure out which plan makes more sense for your college needs.

What Is a Prepaid Tuition Plan?

A prepaid tuition plan enables you to buy tomorrow’s tuition at today’s prices. It locks in the cost of college, so that a year of tuition is always worth a year of tuition. Prepaid tuition plans offer peace of mind by locking in tuition rates. 

The money is invested by the plan administrator to try to provide a hedge against college tuition inflation. This works well when the stock market is booming and tuition increases are modest. 

But, during an economic downturn and for a few years afterward, tuition rates increase at above-average rates and stock prices plummet, squeezing the prepaid tuition plan from two directions. 

Many prepaid tuition plans suffer from actuarial shortfalls, where the prepaid tuition plan’s assets are insufficient to cover projected future college costs. 

Some prepaid tuition plans are guaranteed by the full faith and credit of the state, but it is unclear what this really means in practice. 

Prepaid tuition plans typically react to actuarial shortfalls by closing to new investment, ending the plans and reducing the value of the benefits. Prepaid tuition plans also charge a premium on top of current tuition rates to cover anticipated shortfalls. 

The premiums have increased, so the financial advantages of a prepaid tuition plan are not as good now as they once were. The refund value of a prepaid tuition plan is also limited. 

Only 8 out of nearly two dozen original prepaid tuition plans are still open to new participants, including eight state prepaid tuition plans and the Private College 529 Plan.

A 529 plan provides tax and financial aid advantages to help families invest money to pay for future educational expenses. Contributions to a 529 plan are made with after-tax dollars. Contributions are eligible for state income tax deductions or tax credits in two-thirds of the states. 

Earnings grow on a tax-deferred basis. 529 plan distributions are tax-free if used to pay for qualified education expenses. 529 plans do not have annual contribution limits, but contributions are subject to gift tax limitations. 

A contributor can give up to the annual gift tax exclusion per beneficiary without incurring gift taxes. 529 plans also offer five-year gift-tax averaging, sometimes called superfunding, which is treated as occurring ratably over a five-year period. 529 plans have aggregate contribution limits that vary by state. Most 529 plans provide a menu of one to two dozen investment options, such as stock and bond mutual funds. 

529 Plan Investment Options

All 529 plans offer dynamic investment options, such as age-based or enrollment-date asset allocations, in addition to static investment options. There are two main types of 529 plans, direct-sold and advisor-sold. Direct-sold plans are managed by the state and have lower fees than advisor-sold plans, which are managed by a financial advisor. 

Minimizing costs is the key to maximizing net returns. Most families should choose a 529 plan that charges less than 1% in fees. There may be a tradeoff between low fees and state income tax breaks. 

Generally, families should choose a 529 plan that charges lower fees until the child reaches high school, when they should switch new investment to the state’s 529 plan if the state offers a state income tax break on contributions.

Wyoming is the only state that doesn’t offer a 529 plan. Most offer a direct-sold 529 plan and one or more advisor-sold 529 plans.

What Are the Differences Between Prepaid Tuition and 529 Plans?

Both prepaid tuition plans and 529 plans offer tax and financial aid advantages, as well as other flexibilities. Distributions are tax-free if used to pay for qualified education expenses. 

The earnings portion of a non-qualified distribution is subject to income tax at the recipient’s rate, plus a 10% tax penalty, plus possible recapture of state income tax breaks. 

If a dependent student owns a prepaid tuition plan or 529 plan, it is reported as a parent asset on the FAFSA. This results in a lower impact on eligibility for need-based financial aid. The account owner has the option to change the beneficiary to a family member of the current beneficiary. 

Unlike the Coverdell education savings account, there are no income restrictions on contributions to prepaid tuition plans or 529 plans. Both prepaid tuition plans and 529 plans offer automatic investment options and families can save with both. However, there are significant differences between the two.

State residency is a major factor, as prepaid tuition plans are limited to state residents, while most 529 plans are not. The Massachusetts prepaid tuition plan and the Private College 529 Plan are the only exceptions. 

Eligible colleges also differ. Prepaid tuition plans can only be used at public colleges in the state of purchase. If the student attends a private college or an out-of-state college, the family must pay the difference in cost. However, prepaid tuition plans can be rolled over to a 529 plan. 

Time and Age Limits also exist. Most prepaid tuition plans must be used within 10 years of normal college enrollment, with some states limiting it to 8 years, 15 years or 30 years. The Private College 529 Plan has a limit of 30 years. Some prepaid tuition plans also have age limits, such as age 30 unless still in college, with extensions for military service. Prepaid tuition plans have a limited open enrollment period, while families can open a 529 plan at any time.

There are also differences in the definition of qualified expenses. Qualified expenses for a prepaid tuition plan are limited to tuition and required fees. 

Additionally, 529 plans can be used to pay up to $10,000 per year in K-12 tuition and up to $10,000 (lifetime limit per borrower) in student loan repayment for the student and the student’s siblings.