In addition to the wide range of 529 college savings plans based on tax exempt status, there's an option commonly called "prepaid tuition," which often receives a "529" designation and presents an alternative for college savings. Prepaid tuition 529 plans work differently from tax free 529 plans and come with different kinds of risks and rewards.
How prepaid tuition plans work
Families looking at higher education investment choices can look to prepaid tuition plans as opportunities to pay into an account for their child's college fund at rates that reflect the rising cost of college tuition. The idea is that by going prepaid, parents save a lot of money as higher education costs continue to rise. But, as many financial experts point out, that's not the whole picture, and the idea that you can buy tomorrow's education at today's prices is often a pretty significant misconception.
Not all states have prepaid tuition plans, and existing plans don't all have exactly the same characteristics. Most of them are established for a specific community of local residents planning to use state schools or are based on complicated financial equations about what local parents want out of a savings plan. A range of different characteristics will determine whether a tuition plan is "a good deal" compared to the perhaps more traditional strategy of investing into a tax-free or tax-exempt 529.
Prepaid tuition plans and member schools
A lot of prepaid tuition plans are written according to a set of partnering "member schools" -- often state schools with relatively controlled tuition costs. One way to think about this is that you only get the full tuition benefit if your child goes to a member school -- similar to how medical insurance plans offer full discounts to in-network providers.
The bottom line is that in many cases, parents want to be relatively sure that their children will go to a member school before signing up for a prepaid plan. That means school choice plays a major role in identifying whether you want to invest in a tax-exempt 529 or a prepaid tuition plan.
The health of prepaid tuition 529 plans
There's another incredibly important disclaimer here for prepaid tuition plans: The stated risk may not be the actual risk.
Throughout the economic difficulties of the last decade, many different types of investment vehicles took a hit. The average prepaid tuition 529 is an excellent example.
Finance experts note that a main benefit of prepaid tuition accounts is that states commonly assume certain risks for these plans, while the tax exempt 529 is more of a free-market vehicle for parents. But the very important issue here is that with municipalities facing unprecedented budget cuts, more than a few 529 plans have "defaulted" or folded in some way, leaving parent investors vulnerable. A recent Bankrate article cited the financial troubles of an Alabama prepaid tuition plan, the closure of other state plans, and rising prices for prepaid tuition credits.
At the same time, prepaid tuition plans can be great if they work the way that they are intended. The U.S. Securities and Exchange Commission gives an introduction to both prepaid plans and savings plans, showing how prepaid tuition plans can help parents "lock in" prices, and how many of these plans are "guaranteed or backed" by states.
Another big consideration regarding prepaid tuition plan is their rates. When prepaid tuition plans have foundered but not failed, planners have often made big increases to plan costs. And while prepaid tuition plans can look good up front, they can also carry a lot of expenses that mean parent actually pay a premium to future tuition.
It's smart to look at the relationship between prepaid tuition plans and actual state laws. For example, Savingforcollege.com looked at the pricing of 529 prepaid plans in Florida and found that an investment in one particular state plan would only break even if tuition costs rose by the maximum amount allowed by law: Look closely, and you'll see how the plan's pricing reflects an anticipated 15% annual increase for several years, while Florida law limits state tuition increases to that same amount.
In other words, parents are paying for future tuition at future prices -- if not more. This is just one example of how prepaid tuition plans can be somewhat misrepresented and how parents can fall prey to certain misconceptions about these plans.
It's also important to recognize that municipalities are not infallible, nor are the government-backed investment vehicles they manage. Many families use tax-exempt 529 plans not only because of their simple rules but because of the investor's relative control over the money, along with the initial tax savings this strategy offers. That's not to mention that the IRS has also expanded the use of tax-free 529 exemptions to cover new types of technology resources, such as laptops and mobile devices for learning.
Parents may be more likely to benefit from a prepaid tuition plan if the state offering it is in good fiscal and economic health, if it covers a specific set of state schools that the child can attend, and if it offers relatively low fees and expenses over and above current tuition credit rates.
As finance experts will attest, it's always beneficial to consult your financial planner before choosing a particular plan. Your financial advisor can help you sift through all of the details of either a tax-exempt 529 plan or a prepaid 529 to understand what's best for your family's finances and the future education of your child or children.
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Justin Stoltzfus is a contributor to WiserAdvisor.