Prepaid Tuition: Too Good to Be True?

It’s an alluring pitch: Pay for college at today’s rates and avoid future increases, even if your child doesn’t start college for years and years.

But many so-called prepaid tuition plans charge considerably more than the current rate and do not guarantee that a year’s worth of credit bought today will cover expenses years later.

Unfortunately the factors that make prepaid programs attractive — uncertainty in the financial markets, for starters — pulled the rug from under some state-sponsored plans, causing them to turn away new applicants, or worse, impose unattractive price premiums. These have served some families well, but deserve additional scrutiny.

Prepaid plans are a subset of state-sponsored 529 plans that allow tax-free investing for college. The vast majority of 529s are “savings-type” plans offering a menu of mutual funds that can leave a family open to loss if the stock and bond markets fare poorly.

Just over a third of participating states offer prepaid plans in addition to savings plans, though features vary widely. Participating states include Alabama, Colorado, Florida, Illinois, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Ohio, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, Washington and West Virginia. There is also a nationwide Independent 529 Plan that can be used at nearly 250 colleges.

Because fund assets sometimes fall short of their obligations, some plans close their doors from time to time, refusing existing customer’s contributions or simply declining to sign up new ones.

Except for the nationwide plan, prepaid plans generally require that the contributor, beneficiary or both be current state residents, a requirement not found with most savings 529s. In most cases, the contributor chooses an option for determining the account’s future value. It might be tied, for example, to the future rates charged by the state university system, or an index of private college costs. If the beneficiary doesn’t attend the designated school, the account can be converted to an equivalent cash value or even used at another school generally anywhere in the country.