Do You Need a 529 Prepaid Tuition Plan?

This is the last of three posts on 529 plans.  Read the introduction here and learn how to pick the best 529 savings plan here.

529 plans offer a tax efficient way to save for your child’s college tuition.  You can do this through a savings plan or a prepaid tuition plan.  Which is right for you?

Savings plans function like a traditional investments where you deposit money, watch it grown, and take it out when the time is right.  With savings plans, parents may lose money during market crashes (a.k.a. market risk) and or their money may be outpaced by the 5% annual rise in tuition (inflation risk).  Both those risks go away when using a pre-paid tuition plans.

If you’ve already paid for college, it doesn’t matter how expensive tuition is tomorrow, or how far the market crashes… you’re done paying for college.

With pre-paid tuition the college or state become responsible for any market risk or inflation risk.  If they can’t invest properly or keep costs down, it is (theoretically) their problem.

But that doesn’t mean pre-paid plans is risk-free.  Plans will eventually go bankrupt if they continually make poor investments.  If that happens either colleges will have to foot the bill or everyone invested in the plan will lose.  So do your research.  Most plans should be able to offer you information about the performance of their portfolios relative to the rise in their tuition.  You’ll be ok as long a the investments grow faster than tuition.

However, we can’t go on until we discuss the most important risk of pre-paid plans… school choice.  You may lose some or all of your money if your child decides to go to the wrong college or if they are unable to get into a participating college.  If that happens, some plans allow you to cash out your account (for a large fee) or transfer the account to another child (for a smaller fee).  Read the fine print of your plan to see what would happen to you.

Regardless of  market fluctuations or tuition increases, a college credit purchased today in a prepaid plan will be redeemable for one credit in 10, 15 or even 20 years.

Tuitions keep rising, so the earlier you pay for college, the cheaper it will be for you.  When my father attended college, hey may have paid $20,000 all-in to earn his degree at UC Berkeley.  By the time I was ready to graduate in 2009, I’d spent $200,000 at Northeastern.  If this trend continues, my kids may get buried by a $2,000,000 bill before they can don a cap and gown.  Paying early will spare you a headache tomorrow.

Tuition has risen wildly in recent years.  Across the country, bills rise an average of 5% each summer.  But your school may vary.  University of Hawaii, for example, increased 136% between 2004 and 2014.

529 plans can be purchase with pre-tax tax dollars.  And because pre-paid tuition plans are not investments that grow or produce profits, there are no federal income taxes on the other end when your child eventually takes their classes.  Depending on your state’s regulations, you may also get a state tax deduction as well.

The crash of 2008 wreaked havoc on financial institutions across the country, it also forced many states to reevaluate or close their pre-paid tuition programs in the face of rising cost and shrinking returns.  As of 2017, there are only 13 states with plans:

  • Alabama, Florida, Illinois, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Nevada, South Carolina, Texas, Virginia, & West Virginia

If you don’t live in any of those states, or if you plan to send your child to a private institution, you may want to consider the Private College 529.  This is a plan will prepay tuition at any of the nearly 300 participating colleges and universities.

A final choice could be to purchase a plan through a private broker.  These plans may cost a bit more, but provide more flexibility.  They may cover tuition at more institutions, but they are also the only plans that can be used to pay for room, board, books, and related expenses.  If your plan doesn’t cover those costs, be sure to budget for them separately.

There are many tips out there on how to make the most of your pre-paid plan, including these ones from US News and World Reports.

To save money you may want to consider sending your child to a community college to earn an associates degree before transferring to a 4-year college.  If both institutions are covered by your pre-paid plan, your money may go further at the community college.  Alternatively, you could pay for community college course out-of-pocket and save your pre-paid plan for more expensive courses at the 4-year school.  You will or course need to read the details of your plan to see which schools are covered and how that money is applied.

I hope you’ve enjoyed this mini-series on 529 plans.  If there is anything else you’d like me to research or discuss, please let me know in the comments.