What About Prepaid Tuition Plans?

Updated on July 10, 2007.

IF YOU'VE GOT KIDS, just thinking about those looming college tuition bills probably gives you an unpleasant feeling in the pit of your stomach.

Many folks fight through the nausea by steadily saving in a tax-advantaged 529 plan. These accounts come in two basic forms: college-savings plans (which allow people to invest after-tax dollars in a basket of mutual funds, with the assets growing tax free until those college bills start rolling in) and prepaid tuition plans (which allow people to lock in today's tuition prices for set schools, most often public schools in their home state).

In recent years, college-savings plans have been considerably more popular than prepaid tuition plans. Assets in college-savings plans exceeded $97.4 billion in March 2007, according to the College Savings Plans Network, an industry association, while assets in prepaid plans barely reached $15.9 billion.

The reasons for the disparity are numerous. For starters, college-savings plans are easier to understand — they operate a bit like 401(k)s, with the notable exception that withdrawals taken to cover college costs are completely tax free. There's also more of them: roughly 80 compared with the 14 prepaid plans currently in operation. (For a list of the states offering prepaid plans, go to Savingforcollege.com and click on "Plans by Type.") College-savings plans can also be used to cover a wider range of college costs, like books and supplies, whereas most prepaid plans only cover the cost of tuition and fees.

And finally, there's been the financial-aid issue: In the past, college-savings plans were treated more favorably under the federal financial-aid rules than prepaid tuition plans. Benefits paid out of prepaid plans were considered a resource of the child to pay for college. So withdrawals from a prepaid plan reduced federal financial-aid eligibility dollar for dollar. College-savings plans, on the other hand, are viewed as an asset of the account owner (most often, the parent), which means that, when it comes to determining financial aid, no more than 5.6% of the account value is considered available to pay the bills. (This is confusing stuff; for more on this, click here.)

Recently, however, this financial-aid issue has been resolved. Thanks to the Pension Protection Act, a law that went into effect in August 2006, federal financial-aid formulas now treat prepaid plans in the same manner as college-savings plans. In other words, distributions from both types of accounts are viewed as a parental asset.

So does this mean you should now be considering a prepaid plan? We'll be honest: We still lean toward college-savings plans because of the flexibility they offer. But for some families, a prepaid plan may now be the way to go. Here's what you need to know:

Prepaid Plans 101
The basic premise of a prepaid plan is this: You can pay now for future college costs and by doing so lock in today's rates (or close to it — you may pay a slight premium). Considering that tuition and fees for public four-year colleges rose at an average of 7.2% annually from 1990 through 2006, according to the College Board, this is a darn good deal.

But here's the rub: Prepaid plans are tied to a specific group of schools, not the national average. In most cases, they're tied to in-state public schools. So folks living in Florida can invest through the Florida Prepaid College Plan, which covers the average cost increases of Florida's 11 state universities or 28 community colleges, depending on where plan payouts will be used. Of the 13 state-school-oriented prepaid plans currently open for enrollment, only two — Alabama and Massachusetts — allow nonresidents to invest. Then there's the Independent 529 Plan, which covers 264 private universities nationwide. This is open to residents of all states.

This, of course, begs the question of what happens when your child decides to head to a school not included in your prepaid plan. Folks who contributed to the Independent 529 plan, which currently has $135 million under management, are out of luck: The plan will not pay tuition at any nonparticipating school. Instead, account owners can roll over their money to other beneficiaries or to a 529 college-savings plan. Refunds are also allowed, and you will not incur taxes on the earnings and a 10% penalty if the money is used to pay for school. However, the account owner only gets back the principal plus or minus the portfolio's annual rate of return, which is capped at 2%. That's not exactly a good deal: Right now, you could earn a higher return by investing your money in a high-yield savings account.

"We are a prepaid plan, not an investment vehicle, so clearly the value of a prepaid account is locking in today's tuition rate without risk," says Nancy Farmer, CEO of the Independent 529 Plan. (For more on how the plan works, read our story.)

With the state-school plans, however, the results aren't as dramatic. Assets can be used to pay for any college, including in-state private schools and out-of-state public and private schools, says Joe Hurley, founder of Savingforcollege.com. That said, if you bought into your state's prepaid plan, but Junior was accepted to Harvard, your plan will pay you based on the average public college tuition for the year.

Take this example: Nine years ago, you bought two semesters at Illinois's prepaid plan, "College Illinois!" At that time, you would have paid $4,164. Now, as Junior is packing up to leave for Harvard this year, your two semesters are worth approximately $8,500, which is the weighted average of all Illinois public universities. In other words, your investment grew 12% annually. Unfortunately, it still won't cover even a third of Harvard's current tuition bill.

But while the new law does have a big impact on federal financial aid, it doesn't have control over how universities distribute their own institutional money, says Rick Darvis, a certified college-planning specialist and owner of College Funding.

This applies primarily to private schools, which tend to distribute need-based financial aid from their own coffers. (Public colleges, on the other hand, rely mainly on federal financial aid.) In fact, according to Darvis, the average amount of need-based financial aid that private universities give out of their own money covers about 41% of tuition. "The jury's still out on how private colleges will treat prepaid plans," he says.

According to Farmer, of Independent 529 Plan, one of the plan's sponsors — Amherst, Mass.-based Amherst College — has always treated prepaid plans the same as college-savings plans, namely as assets of the parents. So has Boston University, according to Barbara Tornow, senior advisor to the vice president for enrollment. It's still early to gauge other member institutions' intentions, she says, although response to the change has been positive.

Unfunded Liabilities
For parents who are wary of investment risk, the appeal of a prepaid plan's guaranteed return is obvious. In fact, if tuition rates continue going up at the current pace, parents may end up better off in prepaid plans than in college-savings plans.

But it's exactly because of high tuition inflation that many prepaid plans are having trouble proving they can meet their future obligations — much in the way many pension plans are struggling, explains Chris Hunter, program manager of the College Savings Plans Network, an industry group. Currently, five states — Colorado, Kentucky, Ohio, Texas and West Virginia — have closed their prepaid plans to new enrollment because of "unfunded liability," which basically means the plan's assets are less than its liabilities. (Colorado was the only state to close its program permanently; the rest may reopen in the future.)

Should parents be worried? Probably not. "At this point, there has not been any program that has defaulted on current obligations, and when we talk about unfunded liabilities, these are typically 15 to 20 years in the future," Hunter says. In other words, there's time for these plans to make up the gap or for the state to step in.

Many prepaid plans do, in fact, carry some form of state guarantee. Still, Hunter adds, as many as half of the prepaid plans that are open for enrollment currently operate with unfunded liabilities. If that's something you don't like to have in the back of your mind, maybe a college-savings plan is the way to go.