Is your prepaid tuition plan safe?

A popular type of 529, prepaid tuition plans were created specifically to help parents keep up with tuition increases in public colleges. Yet, this week, Alabama state legislators are scheduled to meet to save the state s Prepaid Affordable College Tuition (PACT) Program. And in Texas, legislators are looking for a lifeline for the Texas Tomorrow Fund, which could fall into the red.

The programs are running into trouble from two ends. On one side are states, which are struggling with budget gaps and have been cutting funds to public universities. Universities, in turn, are raising tuition in an attempt to cover their costs. As tuition rises by larger amounts, it s harder for prepaid plans to keep up. Although the plans should be priced to keep with tuition increases, not all were structured to withstand the financial crisis. A few plans are having trouble, like Alabama and Texas, says Betty Lochner, chair of the National Communication Committee for the College Savings Plans Network (CSPN), an association of states that administer 529 plans. But the majority of plans have a model that s working really well.

The troubles in Texas and Alabama began surfacing at least a year ago. The board that oversees the plan in Texas last year suggested lowering the tuition-based refunds owed to parents who withdrew money from the plan before using all the benefits; the proposal was thrown out following public backlash. Alabama suspended enrollment of new participants in 2009, and the plan remains closed off to new investors. In general, closing a plan to new participants might occur when there is a problem, like unexpected investment losses or when a state no longer regulates by how much public colleges can raise tuition, says Lochner.

Currently, 19 states have prepaid tuition plans, six of which (Alabama, Colorado, Kentucky, Ohio, South Carolina and West Virginia) are closed to new investors. Nationally, assets under management total $17.1 billion as of December, up from $15.7 billion in December 2008, and the number of individuals with an account has remained largely unchanged at 2.2 million, according to the CSPN.

Here are five tips for prepaid-tuition plan investors.

Find out if you can get your money back

The safest plans are guaranteed by the full faith and credit of the state, meaning that if a prepaid tuition plan has to shut down, investors can at a minimum get all the money they invested back. Yet, this safety net is only available in Massachusetts, Mississippi, Ohio, Texas and Washington.

In the remaining states, in the worst-case scenario, investors could risk losing the money they contributed to the plan. The chances of this occurring are very slim, says Lochner. To date, a prepaid tuition plan hasn t run out of money to pay back investors. And, she anticipates Texas and Alabama will reach a decision to safeguard the plans at least for existing investors, she says.

Last week, the Alabama House approved a bill to allocate $236 million to guarantee that tuition is covered for students whose families invested in the plan. We support the legislation that's pending to solve the PACT Program for all eligible students, Alabama State Treasurer Kay Ivey wrote in an email. The PACT Trust Fund will continue to pay tuition until otherwise directed by the Legislature or the courts. We support the efforts of Alabama Legislators to solve the PACT program and have confidence that they will be successful.

If your child will start college in the next two years, and you ve been investing in a prepaid tuition plan, you should be fine since most plans appear to have at least enough cash to cover students in the short run, says Mark Kantrowitz, publisher of FinAid.org. If five or more years remain until the student starts college, consider rolling the account over into a traditional 529 savings plan, but find out what type of fees (if any) you ll incur.

Parents who are thinking about investing in one of these plans for the long haul might want to reconsider especially if the plan isn t backed by the full faith and credit of the state, he says.

Higher premiums could be on the way

In most cases, parents payments to a prepaid tuition plan include the tuition cost and a premium (which could run as high as 20% of what you re paying) that the plan charges in order to keep up with tuition inflation and to help build the plan s reserves.

Beware of the likelihood premium hikes, which are typical for states trying to make up for a funding shortfall, says Kantrowitz. Premium increases affect new investors or for new contract or unit purchases that an existing investor makes. (You can buy semesters, quarters or entire years.)

Shifting more risk to universities

A new approach underway with prepaid tuition shifts the risk from the state or the investor to the university. Under this model, if the plan doesn t keep up with tuition inflation, the universities will have to accept less tuition from the participants, says Joe Hurley, founder of SavingforCollege.com. Texas was one of the first to launch this with its newer prepaid tuition plan, the Texas Tuition Promise Fund in 2008.

Consider alternative savings plans

Parents who want exposure to investments like equities that can potentially keep up with the rate at which tuition rises, may want to consider investing in a traditional 529 plan. With this plan, you bear all the risk but you also receive all the rewards. In contrast, the payments you make into a prepaid tuition plan could go toward funding the tuition of current college students while the fate of the plan when your child who is, say, 10 years away from college becomes a college freshman could be uncertain, says Kantrowitz.

Still, a huge advantage of most prepaid tuition plans (when they re run properly) is that once you are in, you re protected from future tuition hikes, says Hurley.

Correction: This story originally stated that assets under management in prepaid tuition plans were $17.1 million as of December 2009, up from $15.7 million in December 2008. The correct numbers are $17.1 billion and $15.7 billion.