Prepaid Tuition Plans

on June 28, 2017

Prepaid tuition plans let people pay for future college tuition and fees at today’s prices. At least, that’s the theory behind prepaid tuition plans.

 

Prepaid tuition plans fall short of the promise in several ways.

  • Most prepaid tuition plans suffer from actuarial shortfalls. An actuarial shortfall means that the prepaid tuition plan will not be able to cover all future obligations.
     
  • Most prepaid tuition plans charge a premium on top of the current cost of tuition to cover the shortfall between the return on investment and college tuition inflation. So, prepaid tuition plans don’t really let you lock in college costs at current prices.

Nevertheless, some people prefer prepaid tuition plans as a way of saving for college because they give them peace of mind. They also are useful in allowing divorced parents to address their responsibilities under a college support agreements.

 

A dozen states offer prepaid tuition plans. There also is a prepaid tuition plan for private colleges called the private college 529 plan.
 

How Do Prepaid Tuition Plans Work?
 

Prepaid tuition plans let families lock in future tuition by buying units that are worth a fixed percentage of a year’s tuition.
 

The state prepaid tuition plans cover only in-state public college tuition. A few have versions that also cover in-state private non-profit college tuition. Options for using prepaid tuition plans at out-of-state colleges vary by state, but can include using the refund value of the prepaid tuition plan or the weighted average of in-state tuition or the out-of-state tuition, whichever is less.
 

The private college 529 plan only can be used at participating private colleges. The refund value of the plan, which can cap the annual return on investment, can be used at other colleges.
 

Prepaid tuition plans require either the account owner or the student to be a state resident.
 

Investments in a prepaid tuition plan are made with after-tax dollars. The account owner has no control over the investments. The earnings accumulate on a tax-deferred basis and are tax free if used to pay for qualified higher education expenses. The earnings portion of a nonqualified distribution is taxed at the beneficiary’s rate, plus a 10 percent tax penalty.

 

Investment Performance

 

Prepaid tuition plans work well when the stock market is rising but not as well when the stock market is falling. During economic downturns, prepaid tuition plans are hit with a double whammy.

  • College tuition tends to increase at above-average rates during a recession and for a few years afterward. State tax revenues decrease, forcing states to cut their budgets. Support of postsecondary education is one of the first budget areas to get cut. Public colleges compensate for decreases in state appropriations by increasing tuition and shifting enrollment to out-of-state and international students who pay higher out-of-state tuition. They also cut other costs.
     
  • Stock market gains are replaced with stock market losses, creating challenges for covering tuition inflation.

Contribution Limits

 

Most prepaid tuition plans allow lump sum contributions. The cumulative contribution limit is typically several hundred thousand dollars based on projections of five to seven years of the future tuition cost of the highest-cost four-year public college in the state.

 

Although most prepaid tuition plans do not have an annual contribution limit, contributions in excess of the annual gift tax exclusion may be subject to gift taxes. A couple can jointly give up to twice the annual gift tax exclusion amount without incurring gift taxes. Otherwise, contributions to a prepaid tuition plan are eligible for the same five-year gift tax averaging as 529 college savings plans.

 

Eligible Expenses

 

Distributions are tax free if used to pay for qualified higher education expenses. These expenses include tuition and fees, books, supplies and equipment and expenses for special-needs services related to enrollment or attendance.

 

Qualified higher education expenses also include room and board if the student is enrolled on at least a half-time basis. Room and board is capped at the housing allowance in the college’s cost of attendance or the amount charged for college-owned or operated housing, whichever is higher.

 

Coordination restrictions preclude using the same qualified higher education expenses to justify a tax-free distribution from a prepaid tuition plan and other education tax benefits. For example, if a prepaid tuition plan pays for tuition and fees, the tuition and fees cannot also be used to justify the American Opportunity Tax Credit (AOTC).

 

Financial Aid Impact

 

The impact of a prepaid tuition plan on eligibility for need-based financial aid is similar to the impact of a 529 college savings plan. A prepaid tuition plan is treated as an asset of the account owner except if it is owned by the student (e.g., a custodial prepaid tuition plan), in which case it is treated as an asset of the dependent student’s custodial parent. The asset value is the refund value.

 

Guarantees

 

Only four of the open prepaid tuition plans are backed by the full faith and credit of the state. Two are backed by the participating colleges, who guarantee that they will accept the prepaid tuition plan in lieu of tuition even if the investment returns fall short. Three have a legislative guarantee, which requires the state legislature to consider legislation to make up any shortfalls, but doesn’t require them to pass the legislation. The remaining prepaid tuition plans do not provide any guarantees.

 

When prepaid tuition plans have run into problems in the past, they typically close to new investment. They also can increase premiums, cap the return on investment and reduce the benefits. Some have attempted to make retroactive changes to the terms, but backed off after public outcry and court challenges.

 

Given that an investment in a prepaid tuition plan doesn’t really avoid the investment risks, you might as well invest in a 529 college savings plan, where you can control the risk and the return instead of relying on a false promise.

 

Portability

 

Prepaid tuition plans often are limited to a specific set of colleges, such as in-state colleges. Families can move before their children enroll in college or their children may decide to enroll at an out-of-state college.

 

Prepaid tuition plans typically offer several options that provide a degree of portability:

  • Investors can roll over a prepaid tuition plan into a 529 college savings plan. The asset value usually will be the refund value of the prepaid tuition plan. The refund value can cap the annual return on investment or be limited to the total contributions, less management fees and cancellation fees.
     
  • Some prepaid tuition plans allow families to use the plans at other colleges but base the distribution on a weighted average of in-state tuition at public colleges or the other college’s tuition, whichever is less.

Resources

 

For more information about prepaid tuition plans, see Chapter 8 of IRS Publication 970, Qualified Tuition Program (QTP).

 

Distributions from prepaid tuition plans are reported on IRS Form 1099-Q, Payments from Qualified Education Programs.

 

Organizations for industry professionals include the College Savings Plans Network (a division of the National Association of State Treasurers) and the College Savings Foundation.

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