The Pros and Cons of Prepaid Tuition Plans
Since they were first introduced two decades ago, Section 529 plans have become a popular way for families to save for their children’s college educations. They are operated by states and educational institutions and offer tax advantages and other financial incentives to help families pay for college without taking on excessive debt.
There are two different types of 529 plans: college savings plans and prepaid tuition plans. College savings plans are basically savings or investment accounts that are used to pay for college expenses, including tuition, books, fees, and room and board. Prepaid tuition plans are a little different: As the name implies, they enable you to buy credits for future years of college now, at today’s prices.
Locking in Tuition Prices
With the prices of college tuition going up approximately 8 percent every year, this “lock-in” feature can make prepaid tuition plans very attractive. These plans essentially enable you to lock in today’s tuition prices to pay for your child’s college education, even if it’s many years in the future.
Like the money contributed to college savings plans, funds contributed to prepaid tuition plans are exempt from federal income tax (as well as state and local income tax in some states) if they are used for qualified educational expenses. Contributions are not tax deductible at the federal level, though some states allow a state tax deduction for prepaid tuition plan contributions.
The other big benefit of prepaid tuition plans is the fact that they are low risk. With college savings plans, you can assume as much or as little risk as you want by choosing high-, moderate- or low-risk investments. With prepaid tuition plans, though, you aren’t really saving or investing money — you’re buying future college tuition. So you don’t have to worry about whether a major market downturn is going to jeopardize your ability to send your kids to college.
In general, either you or your child must live in the state when the account is opened. But anyone is allowed to contribute to the account regardless of where they live, including family friends and grandparents. In fact, prepaid plan contributions can play a role in grandparents’ estate planning strategies.
There are a few drawbacks to prepaid tuition plans that you should be aware of. First, the money generally cannot be used to pay for room and board, so you’ll need to establish a separate college fund to pay for these. Also, having a prepaid tuition plan may negatively impact your ability to obtain financial aid.
Perhaps the biggest potential drawback of prepaid tuition plans is the fact that they don’t offer an opportunity for above-average market returns. This is a simple matter of risk vs. reward: There’s very little risk involved with prepaid tuition plans, but there’s also no way to take advantage of potential market upswings. Your “return” is the long-term savings you’ll realize by buying tomorrow’s tuition at today’s prices.
Which Should You Choose?
So which type of 529 plan is best for your family? The answer mainly depends on whether you value the security and peace of mind of knowing that college is paid for regardless of what the markets do, or you’d rather invest your college savings in the hopes of earning above-average market returns.
If you have questions about saving for college — including deciding which type of Section 529 plan is best for you — please give us a call. We’d be glad to review your situation together and help you choose the right option.