Last week’s passage of the Deficit Reduction Act of 2005 is all but a done deal, merely waiting for a presidential signature. While the legislation contains provisions that hurt college financial aid (and other social) programs, it does contain a “silver 529 lining,” says 529 plan expert Joseph Hurley.

“Money moved from an UGMA/UTMA account into a 529 plan will no longer be considered a student asset in the financial aid formula,” Hurley told attendees last week at a 529 plan conference in Coconut Grove, Fla. Hurley, who founded the Web site savingforcollege.com, writes the ” College Money Guru” column for Bankrate.com.

Instead, it will be considered a parental asset, a good thing because only about 6 percent of parental assets are counted in the federal formula that determines the expected family contribution toward college costs. Meanwhile, a much larger portion — 35 percent — of student assets count, though this is scheduled to decrease to 20 percent beginning with the 2007-2008 school year.

More interesting is that prepaid tuition plans, the forerunners of 529 college savings plans, will now be treated as parental assets in the computation of the financial-aid formula. That’s great news for families who purchased a prepaid tuition plan.

Previously, these plans were penalized from a financial aid perspective because they resulted in a dollar-for-dollar reduction in the cost of attendance, reducing eligibility for financial aid. Their treatment as a parental asset becomes effective in July.

Prepaid plans not a red-haired stepchild

For whatever reason, prepaid tuition programs seem to get little attention among college savings vehicles, as if 529 savings plans were superior in every way. But in my view, locking into and paying tuition costs ahead of time offers a lot of advantages — particularly in an environment where annual tuition inflation rises at more than twice the rate of regular inflation as measured by the consumer price index. You may not be paying today’s tuition rates tomorrow, since future tuition costs are factored somewhat into the price of these prepaid plans, but you won’t have to worry so much about spiraling costs.

Proponents of 529 savings plans say there’s always a chance that investment returns will keep up with and possibly beat rising tuition costs, but that seems like poppycock to me. Yeah, there’s always a chance that you might win the lottery, too.

That’s not to say that you shouldn’t invest in 529 savings plans. The prepaid tuition plans for the most part only cover tuition costs for in-state schools. That represents a substantial portion of college costs, but certainly not everything. Students need food, shelter, books, a computer, notebooks, supplies, etc., to stand a chance of getting good grades. So families that can afford to save money in advance of college costs should consider investing in both types of 529 plans.

But for those families who don’t have a lot of discretionary income, investing in a prepaid plan is much better than doing nothing at all. They offer some peace of mind that, at the very least, the tuition portion of college costs is taken care of. Now that the playing field between the two different 529 plans is pretty even from a financial-aid-eligibility standpoint, prepaid plans are more compelling than ever.

Characteristics of prepaid plans

In his book, “The Best Way to Save for College: A Complete Guide to 529 Plans,” Hurley describes three types of prepaid programs. The most popular is the “contract” program where, as a resident of a state, you purchase in advance a certain amount of tuition credits that can be used at any public college or university within the state. You can make a lump-sum payment or a series of payments over a period of time, typically five years.

Less prevalent than these contract types of prepaid plans are unit programs and voucher programs, which pay a portion of tuition costs using different methodologies. We’ll focus on the predominant contract plan here, but don’t assume that that’s the type of plan available in your state. Check into your state’s program, and learn all the particulars before signing up.

The attractive feature of prepaid contracts is that you don’t incur any investment risk. However, the state plan takes on that risk, and if it doesn’t hire investment managers that are successful, these plans may become insolvent. In that event, a plan may suspend enrollment or shut down altogether (though usually current enrollees get some protection). Programs in Colorado, Ohio, Texas and West Virginia reported problems in recent years.

Generally, the prepaid contract has residency requirements. If your kid wants to go to private school or an out-of-state school, the contract benefits may not fully cover the cost of tuition at the school of choice. Also, it may not make sense to lock into a prepaid tuition plan if there’s a strong possibility that you’ll move out of state in the future.

Most prepayment contracts have an expiration date, meaning that they need to be used within a specific time frame. For example, if benefits aren’t used within 10 years of the time when a child reaches college age, you may get a refund of the original contribution amount. That would not be a good return on investment.

As one example, the Florida Prepaid College Plan gives account owners three options if they face an imminent expiration date. They can extend the plan benefits an additional 10 years, transfer the account to a brother, sister or first cousin of the original beneficiary, or request a refund. Account owners have to notify the plan of a decision in writing prior to the expiration date or they risk forfeiture of all funds.

Prepaid plan options

Prepaid programs typically offer a few plan options. For example, the Florida plan features a four-year university tuition plan, a community college tuition plan, and a “2+2 tuition plan” that covers two years in a community college and two years in a university.

When your children are young, it’s hard to know how motivated they will be to apply to and gain acceptance from a four-year university, so parents have to make an educated guess about what type of plan to buy. If you can afford the four-year university plan and high motivation levels run in the gene pool, then I’d bet on that plan. But if all you can afford is the 2+2 plan, then consider getting that. These plans are flexible anyway, so if your kid’s a latent rocket scientist, you can transfer the benefits to a four-year university.

In any event, there’s nothing wrong with sending your children off to community college for their first two years. What matters most from the perspective of future employers is the school from which they earn their sheepskin. Plus you can really go places regardless of where you start your college career. According to an item that ran in the Wall Street Journal last week, 22 members of Congress have community college degrees, and 11 members have taught at two-year schools.

One might contend that the way to get the most bang from your buck in a prepaid tuition plan would be to attend the most expensive (and prestigious) four-year university in the state. That would be arguably the best course to take. But even if a student ends up at the least-expensive school, it would likely cost less to pay for his or her education in advance than to wait until the student matriculates before you deal with college bills.

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