Financial Planning: What on Earth Is a 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. These plans, legally known as "qualified tuition plans," are sponsored by states, state agencies or educational institutions and are authorized by section 529 of the Internal Revenue Code.

There are two types of 529 plans: prepaid tuition plans and college savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a prepaid tuition plan.

Prepaid tuition plans generally allow college savers to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements. Many state governments guarantee investments in prepaid tuition plans that they sponsor.

College savings plans generally permit a college saver (also called the "account holder") to establish an account for a student (the "beneficiary") for the purpose of paying the beneficiary's eligible college expenses. An account holder may typically choose among several investment options for his or her contributions, which the college savings plan invests on behalf of the account holder. Investment options often include stock mutual funds, bond mutual funds and money market funds, as well as age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.

The following outlines some of the major differences between prepaid tuition plans and college savings plans. (Source: Smart Saving for College, FINRA)

Prepaid tuition plans lock in tuition prices at eligible public and private colleges and universities.

All plans cover tuition and mandatory fees only. Some plans allow you to purchase a room and board option or use excess tuition credits for other qualified expenses.

Most plans set a lump sum and installment payments prior to purchase based on age of beneficiary and number of years of college tuition purchased.

Many state plans are guaranteed or backed by the state.

Most plans have an age/grade limit for the beneficiary.

Most state plans require either the owner or beneficiary of the plan to be a state resident.

Most plans have a limited enrollment period.

With college savings plans, there is no lock on college costs.

The plan covers all "qualified higher education expenses," including tuition, room and board, mandatory fees, and books and computers (if required).

Many plans have contribution limits in excess of $200,000.

There is no state guarantee. Most investment options are subject to market risk. Your investment may make no profit or even decline in value.

There are no age limits. Plans are open to adults and children.

There is no residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers.

Enrollment is open all year.