Definition and Example of a Prepaid Tuition Plan
A prepaid tuition plan is a type of 529 plan that allows an account holder (known as a saver) to buy units, credits, or numbers of years of tuition at participating schools for the future education expenses of a student beneficiary. Applicable expenses include tuition and mandatory fees but not room and board or tuition for elementary or secondary schools. These plans are typically sponsored by states or state agencies, but some private colleges and universities also sponsor them.
How a Prepaid Tuition Plan Works
With college costs soaring, it’s more important than ever for parents to start saving for their children's education early if they have the means to do so. In an effort to make school costs more manageable, some states offer a prepaid tuition plan designed to reward savers for thinking ahead.
The crux of a prepaid tuition plan is that it enables a saver (a parent, grandparent, or other guardian) to pay for the future expenses that a beneficiary (usually a student) will incur at some point in the future at today's rates, thereby guarding against tuition inflation. Savers can pay for those expenses as a lump sum or in installments that they sock away into the plan to pay for units, credits, or a certain number of years of tuition (ranging from one to five years). Schools may range from two-year community colleges to four-year undergraduate programs (and in some cases, graduate school tuition). The plan pools the money and typically invests it according to a long-term investment strategy. It then transfers the funds directly to the participating university when the student starts college.
For example, let's say that Jilin and Kun-Ying live in Texas and have a five-year-old daughter, Lian. They want to pay for Lian's college education within the University of Texas system while minimizing costs to meet other financial goals. They open a prepaid tuition plan, name Lian as the beneficiary, and opt for an installment payment plan where they put money into the plan every month for four years of college tuition at a cost that is substantially less than what they expect it to be by the time Lian is a college-goer. Lian opts to attend the University of Texas at Austin, and when she turns 18 and starts college, the funds that her parents placed in the prepaid tuition plan are sent to the university directly.
Requirements for Prepaid Tuition Plans
As most prepaid plans are state-sponsored, they're typically only available if the saver or the beneficiary is a state resident. Furthermore, not every state offers a prepaid tuition plan. The states that provide a prepaid tuition plan that still accepts enrollees are Alaska, Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington.
Moreover, the participating schools where credits can be bought are usually limited to public colleges and universities. If the beneficiary doesn't attend a participating school, the plan may still pay out but at a smaller amount.
Finally, some plans only allow you to enroll during a specific time of year, and that too, only if the beneficiary meets certain age or grade limits.
If you think you meet these requirements, visit the National Association of State Treasurers "My State's 529 Plan" website, which provides information on the prepaid and education savings plans in each state along with links to plan websites where you can enroll.
Pros and Cons of a Prepaid Tuition Plan
Hedge against tuition inflation
High contribution limits
Ability to transfer plan assets or recoup the principal investment
Limited use of plan funds
Tax penalties for non-qualified plan withdrawals
Lack of financial backing for plans in certain states
The benefits of this type of 529 plan include:
- Hedge against tuition inflation: The main benefit of a prepaid tuition plan is that you can pay for tomorrow's expenses at today's rates, and you can generally rest assured that those rates will be sufficient to cover a beneficiary's education. In fact, most states guarantee that the money in the plan will keep pace with tuition. Some, but not all, states without these formal guarantees often have other measures in place at the state level, such as using appropriations to help recoup funds if the plan fails.
- Tax benefits: Many states offer tax advantages for contributing to 529 plans such as prepaid tuition plans, such as deducting the contributions from state income, but in some cases, only if you're a resident of the state. If you use withdrawals for qualified education expenses, you may also be eligible for tax-free growth of earnings on your investments, which in some cases applies to both federal and state income tax.
- High contribution limits: Each state establishes limits for how much you can contribute to a prepaid tuition plan, but the limit is typically the amount needed to prepay the units, credits, or years of tuition desired, so you can often contribute a great deal to amass savings over time. If you're certain your child will attend an in-state school, these savings can be used to pay for tuition and offset a surprising portion of college costs.
- Ability to recoup the principal investment: If you move or the beneficiary decides to go to school out of state, you can often get your principal investment back (but not the growth).
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 of tax-free growth.
Opting for a prepaid tuition plan can be too restrictive or risky for some for these reasons:
- Geographic limitation: As the money you save can generally only be used in certain states, by in-state residents, and at public colleges and universities, you could be limiting your child’s educational choices later. This is also a drawback if you think your family could move in the future.
- Limited use of plan funds: Room and board aren't typically covered by prepaid plans, so you may still have to foot the bill for other costs at tomorrow's likely higher rates.
- Additional costs: These plans may charge enrollment or application fees along with ongoing administrative fees that can be a financial burden if you don't budget for them.
Check the plan's offering circular, a disclosure document, to assess the fees for the plan.
- Tax penalties for non-qualified plan withdrawals: If you don't use the withdrawals for qualifying education expenses, you could be on the hook for federal and state income tax as well as a 10% penalty on earnings.
- Lack of financial backing for plans in certain states: Some states make no guarantee, official or unofficial, that a prepaid tuition plan will pay your education plan if the plan fails. This means that despite your saving, you could still be on the hook for educational expenses when the time comes for the beneficiary to begin college.
Prepaid Tuition Plan vs. Education Savings Plan
An education savings plan is another type of 529 plan, but one that varies considerably from a prepaid plan. Notably, a prepaid tuition plan is a state-sponsored plan where the plan invests your money according to its strategic objectives, whereas an education savings plan is akin to a traditional investment account where you have more control your investment strategy.
In contrast to the strict requirements for residency and participating schools for prepaid tuition plans, an education savings plan can be used at any college or university in general, potentially even outside the U.S. The definition of qualifying education costs is also broader and includes tuition and mandatory fees and room and board. It can even be used to cover up to $10,000 in tuition at elementary and secondary schools. This makes an education savings plan more practical for those seeking geographic or educational flexibility, whereas a prepaid tuition plan is a more appropriate choice for those who know they will reside in and receive their higher education within a state that offers a prepaid plan.
|Prepaid Tuition Plan||Education Savings Plan|
|State residency requirement||No residency requirement|
|Limited to tuition and mandatory fees||Also covers room and board|
|Less control over investments||Greater control over investments|
- A prepaid tuition plan is a type of 529 plan that lets you prepay for units, credits, or years of tuition at a participating school.
- Parents or other savers who live in one of the 12 states that offer these plans should open plans and name as beneficiaries the students whose educational expenses the plan funds will cover.
- The plans act as a hedge against inflation and come with tax benefits including tax-free growth of earnings but are less flexible than education savings plans so are best suited for beneficiaries who meet residency requirements and plan to attend school in-state.
FINRA. "529 Prepaid Tuition Plans." Accessed Sept. 15, 2020.
Comptroller.Texas.gov. "Texas State Government and Long-Term Obligations." Accessed Sept. 15, 2020.
U.S. Securities and Exchange Commission. "An Introduction to 529 Plans." Accessed Sept. 15, 2020.
North American Securities Administrators Association. "Understanding College Savings Plans." Accessed Sept. 15, 2020.