Prepaid Tuition Plans: Pros, Cons, How They Work & More
A 529 prepaid tuition plan is a tax-advantaged college savings program that allows you to purchase, or “lock in,” tuition amounts at current rates to cover higher-education expenses when your child is of college age. States operating the plans guarantee that funds will rise in value as college tuition costs inflate. In other words, a semester’s worth of tuition purchased today will still be worth a semester’s tuition when your child enters college in 18 years, even if the stock market crashes or if tuition expenses have doubled or tripled by then.
These features make a 529 prepaid tuition plan quite different from a 529 college savings plan. Under the college savings version, funds are invested in a particular portfolio that can grow or decline in value based on market performance.
Like the college savings plan, however, the prepaid tuition plan allows you to name anyone — including yourself — as a beneficiary, and anyone can contribute funds to the plan. But in order to take advantage of its full financial benefit, the beneficiary must attend an in-state public college or university or choose from a select few eligible private institutions.
Below, we compare the benefits and drawbacks of the prepaid tuition option, spell out the rules and costs, and offer useful tips to help you decide if it’s right for you. You can also compare the 529 prepaid tuition plan against other college savings options. Keep reading to learn more.
Pros & Cons Of 529 Prepaid Tuition Plans
Prepaid tuition plans aren’t for everyone. Like any other financial product, it has advantages and risks that you must weigh against other options before making a decision. The following table summarizes the pros and cons that are unique to this option relative to a standard brokerage account.
|Tax-free withdrawals on earnings if used for college||Plan will not pay full amount of tuition if your child attends an out-of-state school1|
|Plan guaranteed to keep pace with inflation||Must be a resident of the state sponsoring the plan|
|Many states guarantee plans against default||Many states have age and grade requirements|
|Bonus perks (e.g., state tax breaks or matching scholarships) for residents of sponsor state||Funds can only be used for college expenses|
|Minimal financial aid impact||Unqualified withdrawals taxed as regular income and subject to 10% penalty|
|Full principal is protected from market fluctuation||No investment options|
|—||Limited enrollment window for the prepaid program each year|
1If your beneficiary chooses to attend an out-of-state school, or if your family moves out of state, some plans will pay only the average of in-state public tuition, and you will be responsible for paying the difference, if any. Others will treat the out-of-state student as in-state.
How A 529 Prepaid Tuition Plan Works
Prepaid plans allow you to purchase tuition credits, units or years either with one lump-sum payment or through monthly installments. When your beneficiary is ready to enroll in college, the plan will pay the school directly for the prevailing rate of tuition.
|529 Prepaid Tuition Plan Features|
|Investment Options||No Investment Options: Participants are guaranteed a specific benefit regardless of interest rates, inflation or market fluctuations.|
|Better Security: Savers do not need to worry about balancing risk and rate of return.|
|Qualified Expenses||Tuition & Fees|
|Books & Supplies|
|Computers & Other Equipment (must be required by the school)|
|Special-Needs Services (must be incurred in connection w/ enrollment/attendance)|
|Eligible Institutions||Most In-State Public Colleges/Universities|
|Graduate Schools (depending on sponsor state)|
|Community Colleges (depending on sponsor state)|
|Out-of-State Colleges/Universities (but you lose guaranteed value of plan)|
|Fees & Costs*||Enrollment Fee: Typically $50 or less and charged by most plans|
|Administration Fee: Equivalent to a percentage of the plan's assets (including both the principal and interest)|
|Cancellation Fee: Typically between $50 and $100|
*In addition to these fees, the price of your plan will be determined before purchase and will depend on other factors such as your beneficiary’s current grade in school (if applicable), the current and projected cost of tuition, and the projected rate of return.
Types Of Prepaid Tuition Plans
Plans are offered and monitored by a handful of states, called “sponsor states,” as well as by certain individual educational institutions. Please note that a prepaid tuition plan in your state or school of choice may not be open to enrollment at the time you wish to apply.
The following table summarizes the three types of prepaid tuition plans.
|Contract Plan||Covers 1–5 years of tuition|
|Pricing based on payment type (lump sum vs. installment) & beneficiary's age (younger = cheaper)|
|Most affordable option for low- & middle-income families who cannot afford to pay in one lump sum|
|Unit Plan||Covers fixed percentage of tuition (1 unit/credit = 1% of yearly tuition)|
|No limit on number of units you can purchase|
|Voucher Plan*||Covers fixed percentage of tuition (similar to Unit Plan)|
|Sold directly by institutions, not by states|
*A national consortium of private and nonprofit schools also offers its own voucher plan formally known as the Private College 529 Plan. As voucher plans stipulate, the funds can be used at member schools only, and the rules differ from those of state-sponsored versions. For instance, enrollment in the Private College 529 Plan is open year-round, whereas state 529 plans have a limited or seasonal enrollment period.
Tips For Buying & Using A Prepaid Tuition Plan
Not all prepaid tuition plans are made equal. You should therefore exercise caution when selecting a contract. The following tips will guide you in that process as well as after you’ve purchased a plan.
- Make Sure The Plan Is Safe: Prepaid tuition plans theoretically increase in value to keep up with tuition inflation. But that doesn’t always happen. Before you commit to a plan, find out if it is expected to grow enough to keep pace with tuition rate inflation . You can do so by reviewing a plan’s annual financial audits, which can be found online.
- Evaluate Your Financial Situation: You need to take a holistic look at your finances before you invest in a college savings program. If you’re in debt or haven’t saved for retirement, for instance, you might be better off tackling those problems first. Sometimes, the best way to help your child is to avoid becoming a financial burden to them in the future.
- Read The Fine Print: Before signing a contract, you need to learn exactly what your plan covers. Keep in mind that room and board are typically excluded from the list of qualified higher-education expenses, so you’ll have to find other means to cover housing. And if you don’t use the plan for its intended purposes, you may face penalties or lose the guaranteed benefits.
- Declare Your Contributions: Contributions aren’t usually tax-deductible. However, some states offer deductions and credits to contributors, so take advantage of them by reporting your contributions on your income tax returns.
- Start Early & Pay By Installment: The primary benefit of a prepaid tuition plan is the ability to lock in current tuition rates, so it’s ideal to purchase a contract before tuition rates inflate significantly. Remember: the longer you wait to purchase a contract, the more expensive the contract will be. And you can pay by installment to make saving manageable.
- Avoid Premature Cancellation: With a full-ride scholarship, your beneficiary won’t need a prepaid tuition plan. However, scholarships can be revoked for various reasons such as if the student’s grades dip below the requirement. In that case, you’ll need the prepaid tuition plan to cover college expenses after all. Keep in mind that there’s no risk to the principal in a prepaid plan, so you won’t lose any money if your beneficiary no longer needs it.
- Downgrading Schools? Downgrade Your Plan: If your beneficiary chooses to attend a two-year community college, you’ll miss out on the benefits of a plan intended for a four-year institution. Community college is usually cheaper, so you might consider switching to a community college plan or paying for the credit hours out of pocket and reserving the prepaid tuition plan for when your beneficiary transfers to a more expensive school.
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