Compared to 529 Savings Plan, 529 Prepaid Tuition Plan is a completely different animal.

How It Works

529 Prepaid Tuition Plans are offered by states, which guarantees that contribution to the Plan will appreciate at a rate comparable to tuition rate increase in the state the Plan is offered.

Pros

- Peace of mind: You don't need to worry about which investment to choose and bother about rebalancing; you know for sure the money you put to 529 Prepaid Tuition Plans will match the tuition growth. (On the other hand, you should take this with a grain of salt: the guaranteed investment return in 529 Prepaid Plans is usually pegged to in-state publich schools, which may or may not match the college expense growth in private colleges.)

- Scale: The maximum amount of money you put towards 529 Prepaid Tuition Plans is usually much lower than you could contribute toward 529 Savings Plans, but it is still a large amount compared to the contribution limit in all types of IRAs.

- Donor Stays In Control: Same as 529 Savings Plans, the named beneficiary in 529 Prepaid Tuition Plans usually has no access to the funds. In addition, donors can change beneficiary to other members in the immediate family, usually without income tax consequences.

Cons

- Unfavorable Financial Aid Treatment: Distribution from 529 Prepaid Tuition Plan is treated as external resources like merit-based scholarships, which will reduce your calculated financial needs dollar for dollar.

- Narrow Scope of College Expenses: 529 Prepaid Tuition Plans usually only cover tuition and fees. Only some of the 529 Prepaid Plans allows to use some distribution for other expenses like room and board.

- Not Enough Return For Long-Term Savers: While college expense inflation is certainly big, it is still dwarfed by the long term return in the financial market. If you have many years (read as 10 years or longer) to save for your kids' college, you will probably better off by investing in the stock market.

My Personal Take

It is never advertised when states are promoting the 529 Prepaid Tuition Plans, but the unfavorable financial aid treatment is really bad news for all parents. If parents keep the same amount of money in regular brokerage account, only a total of up to 25% may be expected from family contribution for four years, compared to 100% once you put the money to these 529 Prepaid Tuition Plans. Especially, if your kids are close to college age, you are probably doing a disservice by contributing to 529 Prepaid Tuition Plans.

Covedell Education Savings Account will be the next college saving tool we will look into.

(This article is a component of the 10-part "Saving for College" series at PFBlog. If you want to read from the start, follow the links at this Table of Contents page.)