Prepaid Tuition: Too Good to Be True?

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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.

Prepaid plans are especially attractive when the stock market is falling, even though savings-type 529s and other college investments may suffer losses. Since values of prepaid plans are tied to tuition rates, which tend to rise two or three times the inflation rate almost every year, a prepaid plan can perform well even when the financial markets are tumbling, and many also offer some provision to avoid or minimize losses.

But plans typically invest participants’ contributions in a mix of stocks and bonds, so weak financial markets can trigger plan closings and premiums on new contributions. If you pay 8% more than a credit hour currently costs, and if tuition then increases only 4% a year, it will take two years just to break even.

Though it seems like a complicated subject, research won’t be too hard. Most likely you’ll be eligible for your state’s plan, plus the nationwide independent plan. Here are key things to look for:

  • Do current charges match current tuition costs? If the charges are higher, it will take several years before the plan pays off, making it unsuitable for a child just a few years from entering college.
  • How strong is the state’s guarantee? Some states hedge their bets, claiming problems with the fund can reduce your investment’s value. Other states guarantee any shortfall in the fund are backed by the state.
  • How flexible is the plan? What happens, for example, if the child doesn’t go to college or you want to shift the investment to another child?
  • What are tax implications? There’s no federal tax on investment gains in any prepaid or savings-type 529 plan. Also, there is no federal deduction on contributions. Some states offer deductions on contributions, while some have tax-free treatment of investment gains. Others offer both.

Prepaid plans are meant to serve families who want to minimize risk. But there’s no guarantee a prepaid plan will be the best choice. If the stock market takes off, with gains exceeding college tuition hikes, a savings-type 529 will fare much better. Still, a prepaid plan that doesn’t charge a hefty premium and offers strong protections is worth considering when evaluating your college savings options.

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