Should You Be Worried About Prepaid 529 Plans?

Question: A client has money invested in a state prepaid 529 plan, but we know some states have struggled to meet their obligations. Is the client's money at risk?

Answer: During times of economic uncertainty, anything that comes with an element of "guarantee" seems attractive to investors--particularly for parents who want to help fund their children's college tuition. To this end, prepaid 529 plans proposed a compelling offer amid quickly rising college costs and a volatile investment climate: Insure against tuition inflation by purchasing future college credits in advance at a set price (usually slightly above today's tuition prices) and receive a tax break to boot.

With tuition rates increasing about twice the general rate of inflation--or about 8% on average--a plan that promises to keep pace with tuition inflation sounds promising. But this guarantee might not be as airtight as it seems. Once touted as a worry-free way to fund a child's college education, prepaid 529 plans are beginning to look less infallible, as some states' plans have struggled to keep up with tuition hikes and recover from losses incurred during the 2008-09 market downturn.

Prepaid Plan Basics
Prepaid 529 plans are distinct from conventional 529 savings plans, where parents invest in a combination of stocks, bonds, and cash and leave it to grow over time. By putting money in a prepaid plan, investors gain the assurance that their outlay will at least keep up with inflation in college tuition regardless of how the market behaves.

Prepaid 529 plans also have similar tax benefits as conventional 529 plans. Qualified distributions are exempt from federal income taxes and might also be exempt from state and local taxes; many states also offer tax breaks on contributions. And there's usually some type of a refund available if the child doesn't end up attending college in-state.

With that said, prepaid plans come with their fair share of stipulations. For one, not all states offer prepaid 529 plans, and investors usually need to be a resident of a given state to invest in its prepaid plan. Additionally, you might not be able to open an account if your child is older and nearing college age, and you'll only be able to contribute to your plan at certain times a year. (The specific guidelines vary from state to state.)

Funds in most prepaid plans will only cover tuition and mandatory fees, not room and board, though some plans allow you to purchase a room and board option or use excess tuition credits for other qualified expenses.

But by far, the biggest caveat is that prepaid-plan program managers assume a specific increase in college costs and manage the program to meet those expenses, wagering that their investment results will outpace tuition inflation. However, history tells us that neither college costs nor the market is predictable. If the former spikes and the latter plummets, prepaid plans could be quickly faced with unmet obligations, forcing them to make changes that could be at odds with savers' goals. That has been the case recently: As the bear market did a number on many prepaid plans' investment portfolios, some have been forced to close accounts, increase the risk level in their investment portfolios, or raise the price of tuition credits. For additional shortcomings of prepaid plans, click here.