Typical 529 plans operate similarly to IRAs. You put money in, sometimes netting a state tax benefit, though not a federal income tax benefit. The interest earned on the account is tax-free, so long as it’s eventually withdrawn to be used for qualified educational expenses.
A cousin to the straightforward 529 plan is a 529 prepaid tuition plan. Not all states offer these, but many do. And in some cases, they can be a good investment for future college expenses. So before you open a regular 529 for your child’s future educational expenses, make sure you at least understand these related accounts to see if one might better meet your needs.
How do prepaid tuition plans work?
Prepaid tuition plans are available either through your state or through the Independent 529 Plan, which is run by a group of private colleges. In most states, either the account owner or beneficiary must live in the state when the plan is opened. But anyone can contribute to the account.
Prepaid plans are basically set up to act as a hedge against the inflation of educational expenses. With these plans, you’re buying future educational credits at today’s prices. The plans come in a couple of main “flavors:” prepaid units and contracts.
Prepaid unit plans sell units that are a fixed percentage of tuition each year. Usually, one unit represents 1% of the year’s tuition. So if you buy 10 units in 2016, you’ll get 10 units, or 10% of your child’s educational expenses when your child goes to college in 2026. Parents can buy as many units as they want each year, though the price of the units increases each year with the price of tuition.
Contract plans sell contracts where the parent agrees to buy a specific number of years’ worth of tuition. The original purchase price depends on the child’s age and the type of payment plan, either lump sum or installment. The younger the child, the lower the contract price. And lump sum plans will be cheaper than installment plans. Any move that gives the state more time to invest the money will reduce the cost of the contract originally.
Prepaid plans are the annuities of the college world, loosely speaking. You’ll get a set benefit later for a set investment now. Except with a prepaid plan, you’re eventually going to get a set number of college credits, rather than a set monthly or annual payout.
Prepaid plans were long touted as a way to get more bang for your buck while saving for college, and a way to hedge against investment losses for the future. College tuition has increased at a rate 3.2% beyond inflation over the past 10-year period. Investors who are worried about being able to beat this performance with investments may be tempted to put their funds into a prepaid plan.
With that said, usually when you remove market volatility, you also remove some earning potential. And prepaid plans have plenty of strings attached.
So what are the pros and cons of prepaid tuition plans? And is such a plan a good choice for your child’s future college needs? Let’s look at the benefits and downsides of each.
Pros and Cons of Prepaid Tuition Plans
As with all investment options, prepaid tuition plans have both pros and cons involved.
On the pro side. . .
- Prepaid plans protect your investment against a market crash or skyrocketing tuition, allowing you to lock in tuition rates.
- You’ll get a good deal on tuition if your child attends a state college or university.
- You don’t need to make investment decisions if you’re hesitant to do so.
- You’ll know ahead of time exactly how much tuition you’ve paid for when it comes to your child’s college education.
- With a contract-based installment plan, you’ll be forced to continue saving for your child’s college education.
- To take advantage of the plan, your child(ren) will need to stick to a state college close to home, which means they’ll be spending less on college in general.
- Many state plans have a default guarantee in place, so you know that your money will be available when you need it.
- Some plans come with additional tax breaks or matching scholarships for residents.
- If your child decides to opt out or go to a school that isn’t covered: While the interest rate with many plans will be less than what you could have earned on the market, it is still more than a Treasury Bill or CD.
On the con side. . .
- You could most likely get a better return on your money if you invested it yourself.
- Only 19 states have plans, and you’ll have to live in the state when you open the plan to take advantage. You could also access 270 private colleges through the Independent 529.
- You’ll get the biggest bang for your buck if your child chooses a state-based, public college or university. Many of the plans only give you your original investment plus a small rate of interest if your child decides to go out out of state or to a private school.
- Parents have less control over contributions, and will need to continue making contributions on a contract installment plan even during lean financial times.
- Prepaid tuition plans cover only tuition and mandatory fees, so it can’t be utilized to pay for books, supplies, or room and board. Basic 529 plans can be used for these, as well as other college-related expenses such as computers and software.
- If the state doesn’t invest the money well or underfunds the plan, you could find that your state can’t back the plan at the time your child is ready to go to college. This may not be the case in states with plans that are guaranteed against default.
- Some of these plans may impose age limits and residency requirements on students using the plan.
- These plans are harder and more complicated to enroll in than regular 529 savings plans.
So, Is It the Right Plan For You?
Prepaid tuition plans have enough pros and cons that this decision isn’t clear-cut. Your choice will still depend on your personal preferences and circumstances.
You can start by finding out if your state offers a 529 prepaid tuition plan. Many states don’t, and some states have shut down their programs since 2008’s market downturn. If your state does offer a plan, be sure to check out the specifics. If not, you might look at an Independent 529 plan or consider the Massachusetts U.Fund prepaid tuition program. This program is open to families across the country.
Other states that offer prepaid tuition plans include Alabama, Colorado, Florida, Illinois, Kentucky, Maryland, Michigan, Mississippi, Nevada, New Mexico, South Carolina, Tennessee, Texas, Virginia, Washington, West Virginia, and Wisconsin.
Some of these plans are more valuable than others, and they each have different rules and regulations. It’s important to do your research on your state’s specific plan before deciding to participate.
You’ll especially want to consider what happens if your child chooses a private or out-of-state school. How much money do you get back? And do you receive any interest on the money you’ve invested? Are you subject to taxes (federal and state) on the earnings? If you risk losing your principal investment, then a prepaid tuition plan may not be right for you. Conversely, if you’ll get a reasonable interest rate on your principal, prepaid tuition plans may work well for you.
The problem with prepaid tuition plans is that none of us has a crystal ball to look into the future. We don’t know if our children are going to go to college at all. Counting on them to choose a college from a select number of state-specific options is even more uncertain.
We also don’t know if college tuition is going to continue to increase at the current rate. We could even be on top of a bubble that’s about to burst.
Sure, you don’t know what return on investment you’ll get if you save in a traditional 529 savings plan. But in this instance, you do have some level of control over the situation. With most plans, you can choose your investments, which lets you make smart choices based on the current market situation.
The bottom line is that prepaid tuition plans can be a good deal in some instances. Say your child is a bit older, for instance, and knows what he or she wants to do in the future. In this case, you might buy into a prepaid plan when your child is in middle school or early high school. You can cover the gap between your current college savings and future expenses, while locking in a lower tuition rate.
Or maybe your family are diehard fans of your alma mater, and it’s a matter of family pride that your child attend a certain school. If you’re reasonably confident that you can force the issue when your child is deciding where to go to college, then a prepaid plan may be a good choice here, too.
But if you don’t know much about your child’s future, plan to move before your child is college-aged, or generally want to get the best possible return on your investment, you’re likely better off with a regular 529 savings plan.