What Is a Prepaid Tuition Plan?

A prepaid tuition plan is one kind of Section 529 plan, also known as a Qualified Tuition Program. Federal income taxes do not apply to these plans, and unlike other 529 plans, prepaid tuition plans allow you to freeze college tuition prices at the current cost of attending an in-state institution. To enroll in a prepaid tuition plan, you purchase shares that are worth the cost of a current in-state education (or a portion thereof). The investment is guaranteed by the state to appreciate at the same rate that tuition increases. The state’s tuition guarantee is based on an average of in-state public college tuition rates weighted by enrollment. Prepaid plans pay for public in-state college tuition and required fees (registration fees, etc.). If your child attends a private or out-of-state school, the plans generally cover the cost of in-state tuition and fees, leaving you to make up the difference. Every state in the U.S. offers some type of section 529 plan, whether it is a prepaid tuition plan or a college savings plan. While most prepaid tuition plans are run by the state and therefore apply to schools in the state where the account owner resides, some private institutions have established their own Independent 529 Plan.

Types of Prepaid Tuition Plans

Two kinds of plans exist:

Prepaid unit plans: You buy “units,” or a percentage of the cost of a college education fixed at the rate determined when the units are purchased. The price of a unit increases with the price of tuition.
Contract plans: You pay for a certain amount of tuition—for example, one, two, three or four years of tuition. The younger the child is at the time of the agreement, the lower the tuition price the state generally offers. You can pay up front or in installments.

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Who Can Contribute to a Prepaid Tuition Plan?

Contributions to a prepaid tuition plan are not limited to parents—anyone can contribute, including grandparents, other family, friends and even your child. The money in the account is managed by you, not the beneficiary.

Tax Status

As with all section 529 plans, prepaid tuition plans are exempt from federal income tax and most state and local income tax. This aspect makes the plans an attractive estate planning option—parents and grandparents can provide for children and grandchildren without being heavily taxed.

What If My Child Doesn’t Attend College, or We Move to a Different State?

If your child does not attend college, the account can be transferred to another family member who does plan to enroll. A 10% penalty tax applies to withdrawals from a section 529 plan account that are non-qualified—that is, for uses not under the umbrella of acceptable educational expenses as per the plan’s requirements. Exceptions to this penalty include cases where the beneficiary dies or is disabled, or receives scholarships. Most plans stipulate that either the beneficiary of the plan or the account owner be a resident of the state in which the account is opened. If you move out of state but your child attends an in-state school, you may be required to pay the difference between in-state and out-of-state tuition. This depends on the school’s residency requirements and the state’s individual prepaid tuition plan.

What Are The Benefits and Disadvantages of a Prepaid Tuition Plan?

Benefits:

·         Most plans boast a better rate of return on investment than bank savings accounts or certificates of deposit·         “Safer” investment—some programs are backed by full faith and credit of the state
·         When the economy is bad, tuition costs rise due to less state funding—other investments dip with the economy but most prepaid tuition plans are guaranteed by the state to match current tuition costs

Disadvantages:

·         There may be better investments with higher return available
·         The plan may be a detriment to students who would otherwise qualify for need-based financial aid, as they might be seen as “assets” during aid calculation
·         Contribution limits capped at estimated average cost of in-state 4-year college education

How Does a Prepaid Tuition Plan Differ From a 529 College Savings Plan?

Although they are both Section 529 tax-free Qualified Tuition Programs, prepaid tuition plans and college savings plans are different on several points:

Depending on whether it is treated as a parent asset or student asset, a college savings plan may have a lower impact on a student’s eligibility for need-based financial aid. However, changes in 2006 allowed prepaid tuition plans to count as a parent asset rather than student asset, with the value being the refund value of the plan.

There is more risk involved in a college savings plan because the rate of return is not fixed. The bright side is that the return could potentially be greater. A college savings plan starts out with riskier investments (which could garner larger returns) and, as the time for attending college approaches, the investments grow more conservative. College savings plans generally offer a variety of investment options rather than a simple fixed return.

A prepaid tuition plan fixes the cost of a four-year college education at the time the account is opened, so its contribution limit is much lower than that of a college savings plan. This limits the amount of tax-free money that you and/or your relatives can pass to your children through the account. (Most savings plans use the average cost of seven years of college to limit contributions.)

Your child is not restricted in the selection of a college by a college savings plan, whereas a prepaid tuition plan pays for average in-state tuition and fees. You don’t have to purchase college savings plans from the state in which you are a resident—you can choose one from any state that best suits your financial situation and goals.

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