Prepaid tuition plans are a type of 529 plan, allowing you to set aside money now for your child’s college education. Prepaid plans allow parents to lock in education costs in today’s dollars, which can save them money in the long run. But these plans are also far more restrictive than 529 college savings plans, which can make them less appealing if you lack certainty about the future.
Here’s what you need to know about the pros and cons of prepaid tuition plans, including how they work and who should consider them.
What is a prepaid tuition plan and how does it work?
A prepaid tuition plan is a college savings plan that allows you to pay for future college tuition at today’s rate. You can purchase units or credits, either in a lump-sum payment or in regular installments.
Then once your child is ready to attend school, the funds are made available to pay their eligible costs. The units or credits you purchase include tuition and fees, but not other expenses like room and board, supplies or equipment.
These plans are typically sponsored by state governments, and they’re offered only to residents of that state. But in some cases, they’re operated directly by private organizations. After you purchase the credits, the plan administrator will invest the money, though your payout in the end is still guaranteed based on current in-state tuition costs.
Also, as with traditional 529 college savings plans, earnings in a prepaid tuition plan grow tax-free, and you won’t pay any taxes on withdrawals as long as they’re used for qualified educational expenses. If you use the money for ineligible expenses, your earnings may be subject to taxes and a 10 percent penalty.
If your child receives scholarships or chooses not to attend college, you can transfer the credits to another child in your family.
Key benefits of prepaid tuition plans
There are several reasons to consider using a prepaid tuition plan instead of other forms of college savings plans.
Protection against tuition inflation
The primary purpose of a prepaid tuition plan is to avoid tuition inflation. According to a report by the Manhattan Institute, the average net cost of a four-year public college has grown 81 percent beyond inflation over the last decade. What’s more, those increases weren’t matched by scholarships and other forms of financial aid.
With a prepaid tuition plan, you may have more peace of mind knowing that your child’s education is paid for, regardless of the economic factors surrounding tuition inflation.
High contribution limits
One of the drawbacks of alternatives to 529 plans are that they limit your ability to save each year. In 2021, for instance, you can save only $2,000 per student per year with a Coverdell education savings account (ESA). With a prepaid tuition plan, however, you can pay enough to purchase all of the credits you need.
Many states offer tax breaks to taxpayers who contribute to 529 plans, including prepaid tuition plans. These breaks can come in the form of a deduction or a credit, depending on where you live.
Additionally, as long as you use the money for qualified expenses, all investment gains made in the account are tax-free.
Key drawbacks of prepaid tuition plans
While there are some clear advantages to using a prepaid tuition plan, there are also some significant drawbacks that could make it less attractive for some.
Inflexibility with school choices
The terms of these plans are typically based on in-state tuition at one of the state’s public colleges. So if your child wants to go out of state or choose a private college instead, you’ll have to pay the difference between the actual costs and what you have in your prepaid tuition plan account.
Additionally, if your child chooses a school that isn’t covered by the plan, you may use only your original principal balance — what you paid into the plan — without any of the investment gains.
Limitations with eligible expenses
Unlike a traditional 529 college savings plan, a prepaid tuition plan doesn’t allow you to use your funds to pay for things like room and board, books, supplies, equipment and special needs equipment. So while tuition is covered, you may want to look for other ways to save to make sure that those additional expenses are also taken care of.
If you end up using your prepaid tuition plan funds for ineligible expenses, your withdrawals may be taxed, and you may be assessed a 10 percent penalty.
No control over your contributions
Once you’ve purchased the credits, you don’t have any control over how those contributions are invested. Instead, you’ll have to rely on the investment managers that work for your state, and you’ll also be reliant on the state’s funds, which cover the difference if the investment performance isn’t enough to cover the inflation of tuition prices.
In the past, some states have closed their prepaid tuition plans to new enrollees and have even closed down entirely because of concerns about funding.
Who prepaid tuition plans are best for
The pros and cons of prepaid tuition plans may give you a good idea of whether they’re right for you. But if you’re still not sure, here are some situations where a prepaid tuition plan could be useful:
- You’re confident that your child will attend an eligible university in your state.
- You don’t want your education savings tied to the stock market — funds are guaranteed as long as the state’s funding is secure.
- You don’t want to deal with the burden of investing your education savings.
As you consider whether a prepaid tuition plan is right for you, it’s important to also consider some alternatives. For starters, a traditional 529 college savings plan provides many of the same tax advantages but is more flexible in terms of your child’s school of choice and the expenses the plan covers. You’ll also be able to direct how your funds are invested.
If you don’t plan on contributing more than $2,000 per year, a Coverdell ESA may also be a good tax-advantaged option.
Finally, if you want to avoid being restricted to certain expenses, which is an issue with 529 and Coverdell plans, you may consider a taxable brokerage account. You won’t get any upfront or long-term tax breaks, but it can give you the flexibility to use your funds however you please without penalty.