by Bradley Streeter

Created on: August 25, 2008

Section 529 of the Internal Revenue Code allows a donor to invest money for the future higher educational needs of a beneficiary with significant tax incentives for doing so. Federal income tax on the gains of a 529 Account is deferred and distributions for qualified educational expenses are entirely tax-free. In addition, many states offer similar income tax treatment and some even offer additional grants and other benefits. Currently, these accounts are only available through a state or through particular participating institutions.

There are two distinct types of 529 Accounts, prepaid plans and savings plans. Prepaid plans allow a donor to purchase tuition credits at a specific institution or good for any state-run institution in a particular state. Savings plans allow a donor to invest in mutual funds, growing a pool of money from which educational expenses can be paid. A good analogy to distinguish between the two types of 529 plans is that they are like retirement plans; the prepaid plan is similar to a pension and the savings plan is similar to an IRA.

A prepaid plan offers the donor a defined benefit, a number of credit hours per dollar spent. This type of plan is advantageous for the donor who wants the school or state to have total control of the money when donated and who knows that his beneficiary only wants to go to a certain college (or a public college in a certain state).

The savings plan, on the other hand, is typically the better choice in that it is far more flexible and should outperform the prepaid plan in terms of purchasing power. Savings plans are only offered by states (not institutions), but allow a donor to invest in mutual funds, often mutual funds managed by private companies. This gives the donor a say in how the money is to be invested, based on their personal tolerance for risk. Alternatively, donors can often choose a target-date fund, which invests in high-risk, high-return securities initially and gradually shifts to low-risk investments as the beneficiary's enrollment date nears. The flexibility of a savings plan is even more valuable when it comes time for a disbursement. Money invested in a savings plan can be spent at any college in any state. It can also be spent on books, housing and other qualified expenses.

Savings plans should also outperform prepaid plans. By purchasing prepaid credit hours, a donor is merely insuring against inflation. For example, the donor is buying a credit hour in 2018 for the price of a credit hour in 2008. However, financial markets have historically outpaced inflation over time. Given current the current poor economy, the further in time the beneficiary is expected to attend college, the greater the likelihood that a savings plan will still be more financially sound than the prepaid plan. Therefore, unless the beneficiary plans to attend college within the next two years, the savings plan is the best financial bet.

While any 529 plan is better than simply putting money aside for college, savings plans are generally the best bet for educational savings. Savings plans are flexible, both in terms of investment strategy and in terms of their eventual use. They are also more likely to outperform prepaid plans. Although prepaid plans are preferable under certain circumstances, a savings 529 plan is the all-around better choice.

Learn more about this author, Bradley Streeter.
Click here to send this author comments or questions.