What Is a Prepaid Tuition Plan?
A Helpful—Or Risky?—Option for College Savings
With college costs soaring, it’s more important than ever to start saving for your child early. In an effort to make those costs more manageable, some states offer a Prepaid Tuition Plan designed to reward you for thinking ahead. However, a prepaid plan is not always the best choice for your college savings. Learning more about how these plans work and how they compare with a more flexible 529 College Savings Plan can help you make the best possible decision for your family and your savings.
What Is a Prepaid Tuition Plan?
Paying for your child’s education in advance seems like a great idea, but there are some pitfalls to be aware of if you take this approach. A prepaid plan is actually a type of 529 plan since they are both covered under the same part of the IRS tax code. However, prepaid plans need to be used in specific states and have less flexibility than traditional 529 plans.
Each Prepaid Tuition Plan has slightly different rules, depending on the state providing the plan, so make sure you review your state’s rules before making an investment. In this article, we’ll provide an overview that reflects most common prepaid plans.
Before deciding on your college savings plan, you need to know:
- What is a Prepaid Tuition Plan?
- What are the benefits and drawbacks?
- How does it compare to a typical 529 College Savings Plan?
- When should I use a Prepaid Tuition Plan?
529 Prepaid Plans Overview
The idea behind a prepaid plan is that you pay the current rate for tuition credits today, and then you can use those credits to cover in-state tuition for your child in the future. Prepaid plans are typically only available to state residents and, since this offer is made by a specific state, the credits can only be applied within your home state.
Furthermore, not every state offers a Prepaid Tuition Plan. As of this writing, the states that still provide a prepaid plan include: Alaska, Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia and Washington. Florida has one of the largest prepaid tuition plans in the nation; their model is copied by many of the remaining states and is specifically designed to send Floridians to an in-state school.
Benefits of a Prepaid Plan
Most prepaid plans do not place limits on how much you can invest, so you can keep contributing to amass savings over time. If you are certain your child will attend an in-state school, these savings can be used to pay for tuition and offset a surprising amount of your college costs.
If you move or your child decides to go to school out of state, you will be able to get your principal investment back, but not the growth and interest in most cases. While getting your principal back is helpful, it means you could fall significantly short of your college savings goal by missing out on one of the best aspects of the prepaid plan—the growth.
You can avoid this by transferring the fund to a younger child who will attend school in the state; this will allow you to keep the funds and get the full benefit from the growth.
Drawbacks of the Prepaid Plan
Opting for a prepaid tuition plan has real benefits for some students and families, but may be too restrictive for others. Since the money you save is only to be used in the state, you could be limiting your child’s educational choices later.
The geographic limitation of the in-state prepaid plan is a drawback if you think your family could move or if your child wants to attend a school elsewhere. Prepaid plans are often heavily promoted by the state hosting them—so it is easy to think that is your only option. Failing to investigate other options may end up costing you in the long run.
Since room and board often not covered by prepaid plans (many cover tuition only), you may want to consider using a 529 College Savings Plan to cover your other costs.
If your family and friends want to help invest for your child’s education, a prepaid plan is not ideal. It is difficult or impossible for others to send money to your child’s account.
While some prepaid plans are backed by the state itself, many are not truly guaranteed and therefore carry higher risks. For example, the Illinois prepaid plan has struggled historically and today, the state is undergoing a budgetary crisis right now and potentially cutting back on a variety of programs.
529 Plans for College Savings
A traditional 529 plan allows you to invest in your child’s education and may have some advantages over your state’s prepaid plan, particularly if there is any chance your child may attend school outside of the state.
Investing in a typical 529 plan allows you to enjoy the tax advantages of saving for your education and choose an investment portfolio that suits your goals. Growth in the account is always tax-free, and withdrawals are tax-free for higher education.
Plus, friends and family members can also contribute directly to a 529 plan. Services like CollegeBacker make it simple to send a gift directly into a 529 College Savings Plan for a holiday or birthday.
Most important of all, a 529 plan can be used anywhere, provided the college your child chooses an institution eligible for federal financial student aid, and the expenses are qualifying education costs. From tuition to room and board, books and even technology, a 529 plan offers more flexibility than a prepaid plan.
Which Should I Use?
When is your home state’s prepaid plan right for you? If the following points apply, then your in-state plan might be a good deal for your family:
- Your state has a prepaid option (fewer than half of states offer this option)
- You are confident your child will attend an in-state, eligible school and that you will actually use the benefit
- You understand exactly how the plan works and know what is covered and what is not covered
- You fully understand the risks and the drawbacks associated with the plan and know what happens to your deposits and interest if your child opts for an out of state school.
If all of the above points apply to you, a Prepaid Tuition Plan may be a great option for your family to help make college more affordable.
For most families, considering a 529 plan for its flexibility and for other families to contribute could be very advantageous. Even if you choose the Prepaid Tuition Plan, you may want to use a 529 plan to pay for other expenses or to enlist help from others. Carefully reviewing your state’s plan and your 529 options will help you make the best possible choice for your child’s future.