Prepaid Tuition Plans Can Still Work

Most families saving for college have heard of tax-free 529 savings plans, but not all of them know about a small subset of 529s: the "prepaid tuition" type that allow you to pay for college at today's prices to avoid higher prices later.

Once the dominant type of 529, prepaid plans have fallen from favor, holding about $24 billion in assets last year compared to $234 billion for savings-style plans, according to the Investment Company Institute, the mutual fund trade group.

Some prepaid plans have run into financial trouble and closed to new savers. Others have undesirable features, like "guarantees" that aren't really guaranteed. But mostly the prepaid category has simply lost out in competition with savings-style 529s that harness the stock market's greater growth potential.

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Still, any family setting up a serious college-savings strategy should at least look at what a prepaid plan offers. As with savings-style 529, gains in the value of a prepaid plan are tax-free if used for approved college expenses like tuition, and some states offer tax deductions on contributions.

"The owner of a prepaid tuition plan contract is shifting the (risk) burden to the prepaid plan to pay for the number of college credits covered in the contract for that beneficiary," says Jamie Canup, an attorney specializing in investment management at Hirschler Fleischer of Richmond, Virginia. That's quite different from the risk the family assumes with a savings-style 529 that owns a mix of stocks and bonds, which offer no guarantee, Canup says.

"Your investments are at market risk with a savings plan," Canup says, "which means you could lose money on your investments, or lose your investment entirely." Of course, a savings plan could also grow faster than a prepaid plan, which rises in value as tuition charges go up.

Fortunately, shopping for a prepaid plan is easier than looking for a savings-type plan. That's because only 12 states offer them, and they require that either the student or account owner -- generally the person who funds the plan -- be a state resident. Prepaid plans accepting new enrollments are offered by Alaska, Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia and Washington. (Check your state even if it's not on this list, because some others offer plans that share some prepaid features.)

There is also a nationwide plan for private colleges, the Private College 529 Plan.

Experts say many families have a serious misconception about prepaid plans, believing they can be used only at the state college or university designated when the plan was set up.

"This is less of a concern than when these plans first appeared, because most plans have a cash-out option," says Liz Miller, president of Summit Place Financial Advisors in Summit, New Jersey.

Credits can to be converted to cash for use elsewhere, even at a private college or university, or at a school in any other state.

The prepaid plan's chief benefit: peace of mind.

"I view the pre-paid plans as an insurance annuity," Miller says. "Just like the annuity you may buy for your retirement, the pro is that there is a future guarantee that may bring you comfort. The con is that there are likely high costs imbedded and if you saved and invested steadily yourself, you could probably do better."

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With all or part of the college costs paid for, you don't have to worry about price increases even if college is many years off.

That would be a relief if the stock market were to tank, dragging down the value of savings-style 529s heavy on equities. Unlike stocks and bonds, college tuition rarely falls, so pre-purchased credits are unlikely to lose value. A prepaid plan thus offers a degree of security. In fact, if the economy and financial markets went into a tailspin, state colleges might have to raise tuition to offset cuts in state funding. A prepaid plan could actually gain value in troubled times.

"Originally, almost all the 529 plans were prepaid plans," Canup says. "Then college savings plans became popular during the late '90s and early 2000s when market returns were high. When the Great Recession hit in 2008, many owners of prepaid plans were pleased that their account values had not fallen the way account owners of college savings plans had experienced at that time."

The longer the period before college starts, the more valuable the protection against future tuition hikes.

"Prepaid plans are most suitable for families with younger children," Canup says.

In many cases, a prepaid plan works best if the student does attend the school designated when the credits were purchased, Canup says, urging investors to carefully study the provisions for converting credits for use elsewhere.

"Much like a health insurance plan, it's important to understand the benefits of going to an "in-network" college (one that is specifically covered by a plan) and the conversion formula used for attendance at an "out-of-network" college (a college not specifically covered by that plan)," 529 plan expert Joseph Hurley writes on his website.

"There is often a haircut to the value (in a cash out)," Miller says.

What's the downside? Unfortunately, prepaid plans are not always as risk-free as they appear. Funds collected by the plan are invested, often in a mix of stocks and bonds, in hopes the assets will grow at least as fast as tuition rates. That means the fund could fall short in a market meltdown.

And while some plans offer guarantees that require the state to provide funding if plan assets fall short of those required to meet its obligation, investors should learn if their states offer such guarantees before putting in their money.

Another issue: sometimes states worried about meeting future obligations impose "premiums" when credit hours are purchased. In effect, you pay more per hour by buying today and using later than if your student went to college right away. Premiums are meant to give a plan a financial cushion.

These and other features vary considerably among plans, so it will pay to study the terms closely.

Note that if a prepaid plan looks attractive, you need not put all your eggs in one basket. One strategy is use a prepaid plan for just part of your college savings, such as enough to cover one of the four years, while using a savings-style plan for the rest of your college investment.

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You could then keep the prepaid credits in reserve in case other college savings have a downturn. The prepaid credits could be used for a student's senior year if they are not needed earlier.

Jeff Brown spent nearly 40 years as a newspaper reporter, columnist and editor, including 20 years writing about investing, personal finance, the economy and financial markets. He spent 20 years at The Philadelphia Inquirer and has been freelancing since 2007.