For Most College Savers, Prepaid 529 Plans Don't Make the Grade

Prepaid 529 plans have been steadily declining in popularity while traditional 529 college savings vehicles have continued to gather assets.

Conventional 529 college savings plans are popular for good reason--they offer lots of advantages and flexibility for college savers. You invest aftertax dollars in a plan, usually age-based, which provides a diversified investment allocation. The investment mix gradually reallocates, too, reducing equities in favor of fixed income as the beneficiary ages. You are not taxed on the money as it grows in the account, and when you withdraw your money, the capital gains are not taxed either, provided you use the money for a qualified educational expense. Some states also offer a tax break on contributions.

But while the tax advantages of 529 plans are certainly helpful, they won't get you all the way. The overall amount you save and the investment returns that you earn are also critical inputs. What if college inflation runs higher than you anticipate, and your 529 balance falls short come matriculation day? Or what if you did save enough, but a swift market downturn wipes out a significant portion of your account balance just before you need it?

Prepaid 529s attempt to hedge those risks. You pay for future college credits today, so you don't have to worry that the market takes a dive between now and when the beneficiary starts school. You also have assurance that your outlay will at least keep up with college tuition inflation, regardless of how much college costs skyrocket. So essentially, you eliminate market risk and inflation risk. (In theory, anyway.)

Further, 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. And many states also offer tax breaks on contributions.

As tempting as their proposition sounds, prepaid tuition plans are better in theory than in reality. In most cases, the same amount of money invested in a conventional age-based 529 college savings plan will go much further, and there are fewer restrictions on how you can use the money.

Plan Design Drawbacks Lead to Shrinking Universe According to data from Savingforcollege.com, there are only around 13 prepaid 529 plans in the United States, and not all of them are open to new enrollment.

Read the fine print before you enroll. One big problem with prepaid tuition plans is that they lack portability. The way many states' prepaid plans work is this: If you buy a tuition credit today, you can only redeem it at full value at a participating in-state public school. If the student decides to attend a private school or an out-of-state public school, some plans will give you an amount based on average tuition levels at the state public institutions. Others will give you back your original contribution plus or minus some small amount of interest, such as 2% or 3%. (In either case, you likely would have done better investing in a conventional 529 savings plan, which allow you to use the money in your account at virtually any accredited college or university.)

Prepaid plans also come with their fair share of stipulations. You usually need to be a resident of a given state to enroll in its prepaid plan. You also might be required to keep your money in the plan for a minimum number of years (three years for many plans), and you might only be able to contribute to your plan at certain times a year. (The specific guidelines vary from state to state.)

Another huge consideration: Make sure you understand what happens if the plan has underfunded liabilities, or if the plan funds are growing at a rate that is not likely to keep pace with tuition inflation. Some states have guarantees in place; others do not. Many college planning experts recommend reading the plan’s annual report, which you can find online.

Do the math before you sign on. Though the conventional understanding is that prepaid plans offer "future tuition at today's prices," some plans actually charge more than the equivalent of today's tuition. Prospective buyers should also pay attention to onetime enrollment fees and ongoing charges associated with the plan.

In addition, though the funds in conventional 529s can be used to pay for room and board, funds in most prepaid plans will only cover tuition and mandatory fees. (Some plans allow you to purchase a room and board option, however, or use excess tuition credits for other qualified expenses.) Make sure you factor the cost of room and board expenses into your plan if you will have to self-fund them.

The Good A large portion of the total assets in prepaid 529s is made up of the Florida Prepaid College Plan, which continues to be a popular option with Sunshine State college savers.

As prepaid tuition plans go, it isn't bad. It's one of the less-risky options, as it's backed by the full faith and credit of the state. (Florida's credit rating is excellent per several credit ratings agencies.) If the student decides to attend a nonparticipating college or university, benefits are paid out at the current rates paid to public universities in Florida.

There's also the Private College 529 Plan, which began operation in 2003. You buy "tuition certificates" from the plan, which is not state-sponsored but rather is owned by nearly 300 participating private colleges.

Because colleges' tuition rates vary and also increase at different rates, the certificates you buy are based on the current price ratio. For example, if you buy a $10,000 certificate today it may be worth 0.33 years of tuition at one school where current tuition is $30,000, and 0.25 years at another school where current tuition is $40,000, according to the Private College 529 Plan website.

If the student decides not to go to one of the participating schools, you can either roll the certificates over to another sibling, or you could request a refund. The refund will be "adjusted based on the net performance of the Program Trust, subject to a maximum increase of 2% per year, and a maximum loss of 2% per year." As I see it, this is a drawback. It limits your losses in down years (to -2%), but severely caps the potential upside to only 2% per year--you would almost certainly earn a better return by investing in a traditional 529 college savings plan.

And the Bad Some states' prepaid plans are clearly not attractive options. Take the cautionary tale of Illinois, a state besieged by budget woes. According to College Illinois, the state's prepaid tuition plan, new contracts have not been sold since 2017, and the plan has reached out to Illinois Governor Pritzker's office for emergency funds to help address the plan's unfunded liabilities. The plan reported that as of June 30, 2020, program assets totaled about $588.6 million, corresponding to a 63.4% funded ratio--an amount sufficient to cover payments only through fiscal year 2024.

The funding initiative looked promising, but then the COVID-19 pandemic changed the state's budget priorities. The proposed $27 million allocation for 2021 (the first of a series of proposed level payments that would occur for more than a decade) ultimately wasn’t included in the budget that the General Assembly approved for 2021.

Also exacerbating Illinois residents' lack of confidence in the plan is the fact that, as opposed to some states', the Illinois' prepaid tuition contracts are not backed by the full faith and credit of the state. (Not that it would be especially reassuring if it was, as Illinois' debt teeters on the verge of a junk rating.) Rather, the College Illinois prepaid tuition plan states it is backed by the moral obligation of the state, which means that the state technically has no legal obligation to cover any shortfall between the plan's current assets and expected earnings, and the anticipated cost of all its current obligations.

Takeaways A prepaid 529 plan could be a suitable choice for a student who is very likely to attend one of the participating schools, provided the prepaid plan offers good value for money as well as reasonable guarantees of safety and reliability. But for most college savers, a conventional 529 college savings plan is better option, as prepaid plans lack flexibility and offer inferior return potential.