Deciding to use a 529 plan, technically called a qualified tuition plan, to save for college is just the first decision among many. When you're contributing you have to decide how you want the money invested. Before you invest, you need to decide whether you want to use a prepaid tuition plan or a college savings plan.
Prepaid Tuition Plans
Prepaid tuition plans are great if you want to lock in your tuition at today's rates for a certain school or group of schools. For example, if you know your child's going to go to a public school in your state, you can invest in your state's plan. Alternatively, some plans are good at a range of private schools across the country. The benefit is that you're locking in your rates and shifting the investment risk to the schools -- if the stock market doesn't do so well, you're already protected. And, you don't have to worry about picking investments. The downside, of course, is that if your kid picks a school not covered by the plan, and you have to cancel the contract, you're not going to get much of a return when you take out your money from the plan. In fact, depending on the plan, you may get only your contributions back, with no interest.
College Savings Plans
College savings plans, on the other hand, offer more flexibility in terms of where the money is eventually spent because you can take qualified withdrawals for any college, graduate school or trade school. However, the drawback is that if college tuition rates increase faster than the returns generated on your 529 plan, you could be left with a big gap to make up when the tuition bill comes in the mail. For example, say you invest $10,000 today. If your investments double, you've got $20,000 to spend at any school. But, if the market grow more slowly, or even loses value, you have to foot the extra bill.
If you choose to use a college savings plan, different states offer different 529 plan options. Typically, states use one or more financial institutions that can then offer a range of investments depending on your risk tolerance. Investments range from guaranteed returns options, which promise a set rate of return and no loss of principal, to more risky but potentially higher return options like mutual funds. Some companies also offer age-based funds, which shift from riskier investments with higher returns to more stable investments as the child approaches college age.
Don't take the choice of investment lightly because you can't go switching around your investments willy nilly. The IRS only allows you to switch your investments once per year, but you can switch it an extra time if you change beneficiaries. For example, say in January you invest the money in a mutual fund, but it starts doing poorly. If you switch to another fund in February, you're stuck with that fund for the rest of the year, no matter how badly it performs.
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