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Choice of 529 Plan Type Not Set in Stone

You can transfer assets between prepaid 529s and 529 college-savings plans, but don't make a habit of it.

Adam Zoll, 12/24/2013

Question: I can't decide whether to open a prepaid 529 or a 529 college-savings account for our baby daughter. If I open one type of account and later change my mind, can I transfer the assets?

Answer: One nice thing about 529 plans in general is that they have rather permissive rules when it comes to transferring assets as long as those assets stay within the 529 wrapper. As discussed in previous Short Answer columns, 529 assets can be transferred between family members and from one state's plan to another's, often without penalty. 
 
The good news is that this flexibility also applies to rollovers between 529 prepaid plans and 529 college-savings plans. To review, 529 prepaid plans allow the account owner to lock in future tuition payments at today's costs, thus providing protection against tuition inflation. With a 529 college-savings plan the account owner picks a portfolio of stock and fixed-income investments, with assets growing (or shrinking) depending on the portfolio's performance. Both account types offer tax advantages in that assets grow and may be withdrawn to cover eligible expenses without any federal taxes owed, and many states offer income tax deductions or credits for contributions.

Availability of Prepaid Plans Limited
At present 12 states offer some form of 529 prepaid plan, according to a list provided by the College Savings Plans Network. They are: Alaska, Florida, Illinois, Maryland, Michigan, Massachusetts, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington, plus there is a prepaid 529 plan for use at private colleges. 

Assets may be transferred from any prepaid 529 plan to any 529 college-savings plan and vice versa once every 12 months per beneficiary, but there may be costs associated with the move. Some plans charge fees for rolling assets over to other plans, so first find out if your plan does this. Furthermore, rolling assets from an in-state plan to an out-of-state plan may mean forfeiting any state income tax break you get on future contributions as well as being required to pay back any deductions you've taken on past contributions (conversely, rolling from an out-of-state plan to an in-state plan may allow you to deduct part of the rollover, as discussed in this article). You're probably best off looking at an in-state option first if this applies to you--all the states that offer prepaid 529 plans also offer 529 college-savings plans except Washington. Furthermore, assets may be transferred not only between plan types but from beneficiary to beneficiary at the same time. For example, assets from one child's 529 college-savings account could be transferred to a 529 prepaid account established for a sibling. 
 
The account holder can transfer any amount up to the value of assets held in the account. So if a prepaid account holds tuition credits currently worth $10,000, the account holder can roll those assets into a 529 college-savings account. Or, if the money is in a 529 college-savings account, it can be transferred to a prepaid plan and used to purchase $10,000 worth of tuition credits (at that day's price). Not all assets must be transferred, so the account holder may decide to transfer some assets to a different 529 account type while keeping the rest where they are. 
 
Be aware that some prepaid 529 plans have open-enrollment periods and that you may only be allowed to transfer assets into a plan during that time. Other plans, however, allow transfers at any time. 
 
To Roll or Not to Roll
Now that you know that transfers between prepaid 529 and 529 college-savings accounts are possible, you need to think about which account type is right for you and, if you've already opened a 529, whether you should consider switching. Prepaid 529 plans are a great way for college savers to guard against tuition inflation, which has been fairly dramatic during the past decade. At the same time, the stock market has seen some dramatic highs and lows, from the gut-wrenching drops of the financial crisis in late 2008 to the record climb we've seen this year as the rebound continues. Here are some numbers that may help.
 
 College Tuition Inflation vs. Stock/Bond Performance
  10-Year Annualized Growth Rate Biggest Single-Year Increase Smallest Single-Year Increase Biggest Single-Year Decrease
Tuition, Fees--4-Year College (public, in-state)
6.7%*
10.4% 2.9% N/A
Tuition, Fees--4-Year College (private) 4.7%* 6.3% 3.7% N/A
S&P 500
7.5%**
30.2% N/A -37.0%
Barclays U.S. Aggregate Bond Index 4.6%** 7.8% N/A -1.7%
Source: Morningstar, The College Board
 Single-year data as of Dec. 20
 * For the 2003-04 academic year through the 2013-14 academic year
 ** For the time period 2003-13, as of Dec. 20, 2013 

As you can see, equities have outpaced tuition inflation during the past decade, though not by as much as one might expect. However, a bit of context is in order here. For one thing, tuition inflation has slowed during the past few years, meaning the 6.7% annualized growth rate of the past decade may no longer be the norm (in-state tuition at four-year public colleges was up just 2.9% on average this year), which means that college savers locking in tuition at today's rates may not be getting as good a deal as they did just a few years back when tuition inflation was much higher. Second, equities have been on a tear the past couple of years, giving those whose 529 college-savings accounts leaned heavily toward stocks a real boost above and beyond the rate of tuition inflation. This year the market is poised to finish more than 25 percentage points ahead of the rate of tuition inflation, which makes a 529 college-savings plan sound like a no-brainer until you remember that in 2008, when the market lost 37%, stocks lagged tuition inflation by about 44 points! 

However, prepaid tuition plans are not completely without risk either. Some of these plans have run into trouble and even closed in recent years because of funding issues, and not all prepaid plans offer a water-tight guarantee that they'll cover all tuition costs. For this reason, it's imperative that you research your state's 529 prepaid plan thoroughly before putting money in it. Read the plan documentation carefully, and if you're unsure what guarantees are included, call the plan and ask.
 
The cyclical nature of the stock market and the changing rate of tuition inflation might tempt some college savers to try tactically moving assets back and forth between 529 college-savings plans and prepaid plans, but that amounts to market-timing and isn't advisable, especially for funds earmarked for a family member's college education. A better bet for investors hoping to harness the market's potential to outpace the rate of tuition inflation might be using a stock-heavy allocation in a college-savings account early on, when you have a long time horizon that will allow you to ride out the market's ups and downs, and then transferring some or all of the assets to a prepaid 529 as the beneficiary approaches college age. By then most age-adjusted portfolios in 529 college-savings plans are tilted heavily toward fixed-income assets as a way to preserve capital and reduce risk, but a prepaid plan guaranteed to match the rate of tuition inflation might serve that role even better.
 
Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.

 

 

 

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Adam Zoll is an assistant site editor with Morningstar.com

 

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