The Downside of Prepaid Tuition

When planning to save for future college expenses, you may run across several options – including insurance policies, savings bonds, retirement accounts and specific education accounts, such as Coverdell Education Savings and Section 529 plans.

Among the options for Section 529 plans are two types of account:  savings and prepaid tuition.  Following is a brief explanation of the two types of account.

Savings-Type 529 Plan

The savings type of 529 plan works much like an IRA or 401(k): contributions are made and the amounts contributed to the plan are allocated among various sorts of investment options, mostly mutual funds or derivatives of mutual funds.  Over time, assuming that you’ve made appropriate allocation choices and the investments grow, the balance of the account will in turn grow, increasing the amount of funds available to pay for college expenses.  Growth in the account is tax-free when used for qualified higher education expenses (QHEE).

As with any investing activity there are risks to investing in these plans – similar to the risks you face in your IRA or 401(k) plan.  It’s possible that your account could lose value at any given point in time (like late 2008, for example) but prudent investment choices, appropriate time-orientation, and risk management can help to assure that your account will grow over time – but there are no guarantees.

Prepaid Tuition 529 Plan

On the other hand, the prepaid tuition type of plan is set up quite differently from any other type of account.  Instead of a savings account, in this case you’re purchasing discounted “units” or semesters of education – which, backed by the sponsoring state, are guaranteed to be traded for equivalent semesters of public college education (in the sponsoring state) when the student reaches college age.

If the student chooses to attend a non-public school or a school in another state, the programs guarantee that the equivalent of the then-current tuition cost will be available to pay the college of choice, even though the cost at that school will be different from the state universities in the sponsoring state.

Just as with the savings-type of plan, growth in the account is tax-free if used for QHEE – and in either type of plan if you choose not to use the account proceeds for education, you can withdraw the value and pay tax and a penalty on the growth.

The Downside to Prepaid Tuition

So, with all the market volatility, you’d think that the prepaid plan is the way to go – after all, this type is guaranteed!  Unfortunately, that guarantee by the sponsoring state is only as good as the state’s finances; these days, for many states, finances are currently listed under the heading of “Deplorable”.  When you couple the finances of the state with the dramatic increases in tuition costs we’ve seen in recent years, someone is bound to take a hit.  Guess who “someone” is?

Many prepaid tuition plans were forced to bar adding new participants to their plans after the dot-com bubble burst several years ago, since poor market returns and higher tuition rates were causing the plans to lose money far too quickly to make up reserve balances.  Now, similar situations abound, and the states backing the plans may or may not have the funds to help shore things up.  As a result, new fees have sprouted for many plans – along with large increases in the discounted costs for new credits being purchased, which chokes off the new money coming into the plans.

According to a recent article in the Wall Street Journal, all across the nation prepaid tuition plans are operating in the red – seems that the market volatility does have an impact on these plans after all, just a little more subtle and after the fact.  And it’s up to the state to determine if their promises are worth keeping… and here in Illinois we don’t have that much faith in our state government. Your mileage may vary.

For my money, it just makes far more sense to use the savings-type of 529 plan: a plan that you can understand, can follow the balance, and perceive how and why fluctuations occur.  With those plans, you know what you have in the account, day in and day out.  With the prepaid plans, especially given the poor fiscal conditions of the states guaranteeing things, it’s all in question, in my opinion.

Photo by Medmoiselle T