Prepaid Tuition Plans

Prepaid tuition plans are tax-advantaged vehicles for saving for college. Investors in prepaid tuition plans buy a percentage of a year’s tuition and are assured that the investment will always be worth the same percentage of a year’s tuition. Earnings accumulate on a tax-deferred basis and are entirely tax-free if used to pay for qualified higher education expenses.

Prepaid tuition plans are an imperfect hedge against tuition inflation. Investors are charged a premium over the current cost of a year’s tuition to compensate for the difference between investment returns and projected future college costs. Many prepaid tuition plans suffer from actuarial shortfalls. It is unclear what will happen if the prepaid tuition plan is unable to fulfill its obligations, even in the prepaid tuition plans that are supposedly backed by the full faith and credit of the state. Historically, prepaid tuition plans have responded to actuarial shortfalls by ignoring them, by closing the plan to new investment, by increasing premiums, by reducing the financial benefits to plan participants and by attempting to retroactively change the terms of the prepaid tuition plan. So, the peace of mind offered by prepaid tuition plans may be more smoke and mirrors than any real guarantee.

Only about a dozen or so of states offer prepaid tuition plans.

Contributions

Contributions to a prepaid tuition plan are made with after-tax dollars. There is no requirement that the donation come out of earned income. Contributions must be made in cash.

Contributions may be made through a lump-sum payment or through automatic monthly payments.

Each prepaid tuition plan sets its own annual contribution limit for monthly payments, generally no more than is required to save the full cost of four years of public college tuition. Otherwise, there is no annual contribution limit. However, annual contributions in excess of the annual gift tax exclusion ($14,000 in 2013, 2014 and 2015 may consume part of the contributor’s lifetime gift tax exclusion, unless the contributor elects to use five-year gift tax averaging.

Contributions are not subject to any age limits.

Investments

Investors in a prepaid tuition plan have no control over the investments made by the plan manager.

Prepaid tuition plans do not work well during economic downturns, when their value is hurt by a combination of investment losses and above-average public college tuition inflation.

Investors in prepaid tuition plans may roll them over into a 529 college savings plan. However, the refund value of the prepaid tuition plan may be less than that suggested by tuition inflation. Some prepaid tuition plans cap the annual appreciation of a prepaid tuition plan when calculating the refund value, and may also subtract annual administrative or management fees.

Distributions

Distributions from a prepaid tuition plan are tax-free if they are used to pay for qualified higher education expenses, which are the same as the qualified higher education expenses for a 529 college savings plan. The qualified higher education expenses include tuition and fees, room and board (if enrolled on at least a half-time basis, subject to allowances set by the school or actual charges for institutionally owned or operated housing), books, supplies, equipment, and expenses for special-needs services required for enrollment or attendance.

Impact on Eligibility for Need-Based Financial Aid

Prepaid tuition plans have a similar impact on eligibility for need-based financial aid as 529 college savings plans. They are treated as an asset of the account owner unless they are owned by a dependent student, in which case they are treated as an asset of the student’s parent. The asset value is the refund value of the prepaid tuition plan.

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