Paying for College: Prepaid Tuition and College Savings Plans

In 2003-2004, tuition and fees at public four-year colleges and universities averaged $4,694, while those at private four-year colleges averaged $19,710. Total charges, including room and board, were $10,636 at public institutions and $26,854 at private ones. Between 1993-94 and 2003-04, average tuition and fees rose 47% at public four-year institutions and 42% at private institutions. (College Board, Trends in College Pricing 2003, p. 3) To cover these costs, students and their families are using loans, grants, savings, and, increasingly, a specific type of college savings plan known as a 529.

What are 529S?

Section 529 college savings plans are named after the 1996 Internal Revenue Code section that confers tax exemption to "qualified State tuition programs" (Hurley, 2002, pp. 12-13). There are two basic types of 529 programs - prepaid tuition plans and college savings plans.

With a prepaid tuition program, families may purchase future college tuition years or units, generally at that state's eligible colleges or universities (or an equal amount toward private or out-of-state tuitions), at current rates. College savings plans allow families to establish, and contribute to, a special savings or investment account dedicated to a student's future higher education expenses at any accredited postsecondary institution. The account is similar to a mutual fund account in that the contributor chooses investments or an investment strategy, usually stocks and bonds in varying proportions depending on the age of the beneficiary and the contributor's tolerance for investment risk.

The ideas behind these plans are not new. The first prepaid tuition plan was introduced in Michigan in the late 1980s (Ma & Fore, 2002, p. 24; Hurly, 2002, p. 12). Today, each of the fifty states, and the District of Columbia, offer at least one plan (either prepaid or savings), and many offer more than one. Initially, there were problems determining the tax status of accounts. The addition of Section 529 to the Internal Revenue Code in 1996, and changes made to that section since then, have clarified and enhanced the tax benefits of these accounts.

Benefits

The most appealing benefit, for many families, is the tax savings. As of January 1, 2002, the earnings on these accounts are exempt from federal taxes, provided the money is used for educational expenses. (This exemption will expire on December 31, 2010 unless renewed by Congress. See Ma & Fore, 2002, p. 25) Although state tax laws vary, many provide for tax deductions or exemptions of contributions and/or earnings.

Another benefit of the plans is their flexibility. Anyone can open or contribute to a 529 plan. Most savings plans do not restrict eligible individuals to their state residents, so families can compare plans from many states to find the one best suited to their needs. Withdrawals from the plans can be used for much more than just tuition - they can pay for fees, room and board, books, supplies, and equipment. Also, the plans can be transferred to another member of the initial beneficiary's family.