FPA                                                             Financial Planning Perspectives

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PRE-PAID TUITION PLANS DESERVE A SECOND LOOK

 

In recent years, state-sponsored prepaid tuition plans have played second cousin to their younger and wildly popular 529 savings plans. While nearly every state offers a 529 plan, fewer than 20 offer prepaid plans. But with college tuition increasing in leaps and bounds, and the stock market in a slump, prepaid plans are looking attractive to families wanting a solid-returning, lower-risk college savings vehicle.

 

Prepaid plans and college savings plans fall under the same section of the federal tax code and share some of the same tax benefits: no income restrictions on contributors, tax-free growth of earnings and tax-exemption of earnings as long as they’re spent on qualified education expenses. But the plans differ significantly in several ways.

 

The primary characteristic of prepaid plans is that they guarantee, in general, that your investment in the plan today will keep up with future increases in school tuition. Until recently, only states sponsored prepaid plans. Now some private colleges offer them.

 

Returns on investments in 529 college savings plans, which are placed in mutual-fund type accounts, are not guaranteed. On the other hand, you have the potential of earning more overall than the annual increases in state tuitions.

 

But two factors are driving renewed attention to pre-paid plans. First, the decline in the stock market since March 2000 has damaged returns for college savings plans, just as it has hurt returns for mutual funds. Worse, many investment experts are predicting market returns in the next 10 to 20 years to average lower than the historical average (around 11 percent).

 

Meanwhile, college tuition increases, which had been running four to five percent annually in recent years at state schools, have jumped dramatically. Average tuition costs at four-year public institutions rose nearly eight percent for the 2001–2002 academic year. More ominously, several state schools, hit hard by budget cuts from revenue-strapped states, have already announced tuition increases of 10 to 20 percent for 2002–2003. Prepaid plans would guarantee that such huge increases would be covered, while investors in state-run 529 plans can only hope the market will perk up.

 

The investment return on prepaid plans doesn’t precisely follow the average rate of increase in the state’s public colleges and universities. It’s a bit more complicated than that. For example, with programs using “contract” plans in which families buy in a lump sum or a series of payments a specified number of years of tuition (versus buying “units” representing a fraction of tuition and fees), you can end up buying tuition at a discount or at a premium. This depends in part on your child’s age at the time you join the plan, number of credit hours eventually taken and which state institution the child ultimately attends.[Hurley’s article in 529 file]

 

Collegesavings.com gives the example of an Alabama family buying a contract for their 8^th grade child. If the child ultimately attends the more expensive University at Montevallo, they receive a 7 percent discount. If the child attends Alabama State University, they pay a 24 percent premium.

 

Predicting the precise returns upfront is impossible, but an April 2002 article in the Journal of Financial Planning concluded that the average annual after-tax return of prepaid tuition plans since 1991, based on a hypothetical national plan, was 6.3 percent. It returned this with one-fifth of the risk of the S&P 500.

 

But return isn’t everything. College savings plans offer several advantages over prepaid plans, including

• Dollars saved in prepaid plans currently reduce federal financial aid more than dollars saved in 529 plans.
• Prepaid plans typically restrict participation to state residents. Savings plans don’t.
• Although you can use your state’s prepaid plan for schools outside your state, the plan is tied to your state schools’ costs, which may fall short of an out-of-state school.
• Refunds from canceled prepaid plans tend to be more restrictive, in some cases forgoing earnings.
• Many prepaid plans limit investments to tuition and fees, whereas investments in 529 plans can cover a broader range of qualified education costs, such as housing and food.
• Prepaid plans often have specific enrollment periods, unlike 529 plans.

 

A financial planner who is knowledgeable about your state’s prepaid plan can help you weigh the critical factors of the plan to determine its potential attractiveness compared with other college financing alternatives.

August 2002— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by  Rich Chambers, CFP^®, a local member in good standing of the FPA.

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