Are 529 Prepaid Plans All They're Cracked Up to Be?

When people talk 529s, they are usually referring to 529 college-savings plans. Offered by nearly every state and the District of Columbia, these plans allow college savers to invest for college without paying federal taxes on the earnings. (States generally offer their own tax incentives to 529 savers, too.) However, for those with a tidy sum of college savings on hand already, 529 prepaid plans make a different offer: Buy tomorrow's college tuition at today's prices, tax advantages included. Considering the rate of inflation for college tuition (somewhere between 6% and 9% over the past several decades), that's an enticing proposition.

Be careful. Although prepaid plans seem like a great way to get a handle on ballooning college costs, they have a few distinct disadvantages, and at least one prepaid plan has already disappointed college savers. In this article, we'll discuss the details of prepaid plans and what you need to consider before buying in.

Understanding the Basics
When a college saver purchases a prepaid plan, he or she is usually buying a percentage of college tuition at today's prices or locking in the cost of a set number of semesters for various state colleges and universities. Thus, even if the market takes a downward turn, the prepaid plans should allow investors to keep pace for college inflation. The tax advantages add to these plans' appeal: Qualified distributions from in-state plans are exempt from federal and state taxes and contributions to prepaid plans are tax-deductible in many (but not all) states. Formerly, there was one major disadvantage related to financial aid. Because the assets were counted as the beneficiary's, they reduced financial aid awards dollar-for-dollar. Now, however, the assets are considered the account owner's, so their impact on financial aid isn't anywhere near as adverse.

Taking a Closer Look
For the right college saver, the plans might sound like a great deal. Before jumping in, however, consider these restrictions. Prepaids generally require the account owner or the beneficiary to be a resident of the state offering the plan, at least at the time the account is established. Plus, college savers generally can't open accounts for older beneficiaries just a few years away from college.

There's not a lot of flexibility, either. College savers can usually contribute to the plan only at certain times each year, and unlike college-savings plans, prepaid plans often cover just tuition and mandatory expenses, so costs like room and board need to be funded separately. Plus, these plans are generally aimed at in-state colleges and universities. While many plans can also be applied to private or out-of-state schools, the prepaid dollars likely won't go as far, because private schools can cost more and many plans don't promise to keep up with out-of-state college costs. Finally, should you need to terminate the plan, you may receive back only your original contribution without much adjustment for locking it away (you'll likely also face cancellation fees).

These limitations are bad enough, but it can get worse. Prepaid plan program managers assume specific increases in college costs and manage the portfolio of prepaid-plan contributions to meet those expenses. (In essence, the university and the plan manager are wagering that their investment results will best the rate of inflation for tuition and other college costs.) College costs aren't always predictable, though, and neither is the stock market. Should college costs spike or the stock market plummet, prepaid plans could end up facing quickly approaching obligations without the funds to meet them. Some states, including Texas and Virginia, say they will cover shortfalls with other state revenue if the plans' assets don't keep up with college costs. But that isn't always the case. In 2002, the combination of rising college costs and the prolonged 2000-02 bear market forced the Colorado Prepaid Tuition Fund to close its doors to new contributions. The plan gave current participants the choice of either withdrawing a full refund of the money they had invested so far or earning a maximum return of 5.5% in each coming year, regardless of how high college costs rose.

Factors to Consider Up-front
Given the drawbacks, prepaid plans require careful consideration. If the student you're funding has rock-solid plans to attend an in-state university, you've already got some cash socked away, and you want to take a conservative approach to college planning, it might make sense to investigate your prepaid options, but read the fine print closely. Understand whether your particular state guarantees the payout and get a sense for the kind of fees you'll be paying to buy at today's costs (aside from the plan application fee and other niggling expenses, you're paying a premium for college tuition, because the assets aren't managed for free). Compare what you expect to get from your prepaid plan with other options, such as 529 college-savings plans, home equity loans, and the like. For the savvy investor willing to risk the chance of falling returns, it might be a better choice to open a standard brokerage account and aim to earn higher returns than the rising costs of college, even though you'd be giving up the tax advantages. Remember that saving for college is one of the bigger financial goals you'll face, so it makes sense to make a thoughtful decision.