Updated on January 17, 2022. Originally posted on May 16, 2019.
What is a prepaid tuition plan?
A prepaid tuition plan is a type of 529 plan, not to be confused with the savings variety, that allows account holders to lock in future tuition costs at today’s rates.
According to Investopedia, “Timing and age [are] a crucial factor with prepaid tuition plans, as most require plan participation for at least three years before funds can be used, and that the beneficiary be 15 years old or younger at the time of account inception.”
Why are prepaid tuition plans beneficial?
For many of you reading this blog today, the prepaid tuition “boat” may have already sailed.
But if you are a parent that has the luxury of time, here are some of the advantages to using your state’s prepaid tuition plan:
- Potential to pay less out of pocket for college tuition and fees in the future
- The state bears the risk of significant increases in tuition expense rather than the investor
- After-tax funds contributed to prepaid tuition plans are exempt from federal income tax and state income tax (if applicable) as long as the funds are used for qualified education expenses
- Less market risk than a 529 savings variety plan; you likely won’t lose your prepaid tuition money in a stock market crash.
- Note that there is still some amount of risk attached – discussed in the section below.
Which states offer prepaid tuition plans?
Currently, there are nine states that provide prepaid tuition plans, down from 18 not too long ago.
On April 30th of 2019, for example, the Commonwealth of Virginia officially closed enrollment for its Prepaid Tuition 529 due to funding concerns. The good news is that Virginia has put together a revamped plan that may open for enrollment in 2022.
Here is the line-up of states offering prepaid tuition plans at the present time:
Not all of these plans are backed by the full faith and credit of their respective state. Michigan, Nevada, Pennsylvania, and Texas do not provide a guarantee and thus could terminate or change their plans at any time.
Furthermore, unlike some of the 529 savings plans, you must be a resident of the state to utilize its prepaid tuition plan.
Why are these plans disappearing?
The reality is that tuition is rising at a rate much higher than other sectors of the economy, and many states simply can’t afford to take on the risk. As shown by the chart below, college tuition & fees have increased by almost triple the rate of consumer goods (not including food & energy) since 1985.
Source: The Balance
Why wouldn’t someone want to lock in tuition rates with a prepaid tuition plan?
- These plans are meant to be used for in-state public colleges/universities. While you can use them to pay for private colleges or out-of-state schools, you will not get as much bang for your buck. In this case, you would lose value on your savings.
- Most of these plans only cover the cost of tuition and fees, which might only be half the total cost of attendance.
- If your children decide to not go to college and you decide to use the funds for something other than qualified education expenses, the earnings (not the contributions) are subject to state and federal tax in addition to a 10% federal tax penalty.
- Many of these plans are not backed by the full faith and credit of the state and thus are technically at risk if the program can’t afford to pay the tuition in full.
Can you transfer these plans to another child?
Most states will allow you to transfer the prepaid tuition plan credits between members of the same household, so there is less risk with this kind of plan if you have more than one child that is planning to attend an in-state public college.
Why a 529 savings plan may be a better option
For families with only one child or where there isn’t as much certainty as to where the student will want to study, it is probably a better strategy to invest in a “savings variety” 529 plan which can be used for any qualified education expense in the world as long as the school is accredited.
If you live in one of the nine states listed where a prepaid plan is available, you have more than one child, and you expect at least one of your kids to go to an in-state public school, the prepaid plan is a fairly safe option to cover tuition expenses.
The problem is that it only covers tuition, and it’s hard to accurately forecast where your kids will go to college or IF they will go to college. Thus, maybe a combination of a prepaid tuition plan and a 529 savings plan could be used to cover all future costs.
If you want to ensure that you are saving and paying for college with the most efficient dollars possible, consider speaking with a financial advisor who understands college funding and can tailor a strategy to your family’s unique situation.
If you have any questions regarding prepaid tuition plans or the broader strategies of college funding, please feel free to reach out to me at firstname.lastname@example.org.