Prepaid 529 Plans Becoming Rarer

Note: This article is part of Morningstar's October 2014 College Planning Report Card special report. This article originally appeared July 29, 2014.

Question: I used to hear a lot about 529 prepaid tuition plans, but lately it seems like I've heard very little. Are they still around?

Answer: 529 prepaid tuition plans, which allow account owners to purchase credits today that can be used to pay tuition when the beneficiary reaches college age, are indeed alive and well, although perhaps not as well as they were in the past.

Twelve states offered prepaid tuition plans as of the end of 2013, according to data from the College Savings Plans Network, or CSPN, which provides information about state-sponsored college savings programs. There is also a prepaid tuition plan for private colleges called the Private College 529 Plan. States offering prepaid tuition plans (or a variation thereof) are the following:

• Alaska
• Florida
• Illinois
• Maryland
• Massachusetts
• Michigan
• Mississippi
• Nevada
• Pennsylvania
• Texas
• Virginia
• Washington

By far the most popular of these is Florida's prepaid plan, with nearly $10 billion in assets and more than 500,000 accounts as of the end of 2013. The next-biggest prepaid tuition plans are in Washington and Virginia, with $2.5 billion and $2.2 billion in assets, respectively. Prepaid plans typically require that the beneficiary or account owner be a state resident.

Falling Prey to 'Perfect Storm'
While some plans have been successful, others have not. In recent years, several prepaid tuition plans have closed their doors to new participants or dissolved altogether, including plans in Alabama, Colorado, Kentucky, Ohio, South Carolina, Tennessee, and West Virginia. Michigan and Texas have closed the original versions of their prepaid tuition plans to new participants and now offer new plans with different provisions.

"Plans have closed for different reasons," says Betty Lochner, chair of CSPN and director of Washington's prepaid plan. "When you're talking about prepaid plans, every single one of them is unique" in terms of its funding and demographic picture.

Plans generally are designed to be self-sustaining, with the amount of assets in the plan, the investment return on those assets, and the rate of tuition inflation all factored into actuarial calculations that determine how much the plan charges today for tuition credits--called contracts or units--to be used tomorrow. "But what happened nationwide is that we went through this Great Recession and tuition skyrocketed and investments dropped. So it was a perfect storm," Lochner says.

With tuition rising faster than plans had anticipated, stocks tanking (before eventually rebounding), and interest rates plummeting to historic lows, prepaid plans had trouble making the math work. Several closed or were redesigned. Lochner says account owners in these plans had the option of rolling prepaid 529 assets into their state's 529 college savings plan or cashing out, although doing so could trigger an income tax bill.

Lochner says that closing the plans was the responsible thing to do. "In many cases, they decided it was not in the best interest of participants to have a product that might eventually lose money for the participant or for the state," she says. But the good news, she adds, is that no one has ever lost their original investment in a prepaid 529 plan. Some investors, however, have lost money in 529 college savings plans, which allow account holders to invest assets earmarked for college in the stock market.

Ultimately, the long-term success of prepaid tuition plans likely will be dictated by the future rate of tuition inflation, investment performance, and the number of participants in each plan--all of which factor into how much the plan charges for the purchase of its tuition contracts or units. "Prepaid plans work great if they're priced right," Lochner says. 

Don't Ignore the Fine Print
If you are considering opening a prepaid 529 account, or if you already own one, it's important to understand some basic plan rules, including where plan contracts or units may be used. In addition to covering tuition at in-state schools, the contracts or units may be usable at out-of-state schools as well. However, if used for out-of-state tuition, their value typically is limited to the average in-state tuition for the state in which they were purchased, meaning they likely won't cover all out-of-state tuition costs. Also, having a prepaid 529 account in the beneficiary's name is no guarantee that he or she will be admitted to an in-state school. So, if the beneficiary doesn't attend college for whatever reason, assets in the plan must be transferred to a 529 account in another family member's name or taken as an unqualified distribution, in which case the money may be subject to taxes plus a penalty.

It's also important to have a clear understanding of the plan's financial guarantees. Some plans offer what is called a full-faith guarantee, meaning that the state is obligated to step in and provide funding if plan assets fall short of those required to meet its obligations. However, not all plans do this. While prepaid 529 plans in Florida, Massachusetts, Mississippi, and Washington include a full-faith guarantee, plans in Alaska, Michigan, Nevada, and Pennsylvania provide a guarantee that is tied only to the amount of assets in the plan, according to data from CSPN. Texas's new plan provides no guarantee of any type. The remaining states--Illinois, Maryland, and Virginia--offer what are called legislative or statutory guarantees, meaning that the governor is obligated to request funding to cover any shortfalls. But such expenditures must be approved by state legislatures, adding an element of uncertainty regarding what happens if assets fall short.

Of course, given the plans' residency requirements, shopping around for a prepaid 529 plan isn't usually an option. You either like your state's plan and think it's a good hedge against tuition inflation, or you don't. Whatever your choice, just make sure you have the facts on your side.

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