Revitalized Prepaid College Tuition Plans Have Drawbacks Returns Low, May Offset Financial Aid

Recent tax law changes are reviving interest in a decade-old program that lets some families pay future college costs at today’s rates.

These “prepaid tuition plans” are now available in more than a dozen states. Nearly two dozen others have legislation pending, and the rest, except for Georgia, are conducting formal studies. Several private schools also are considering their own programs.

Washington will implement its plan next spring.

Much of the heightened interest has occurred since last summer, when Congress granted the plans favorable tax status after years of confusion. It allowed the investment earnings to be tax-deferred federally until a student reaches college age, after which the withdrawn funds would be taxed at the student’s rate.

Some states had essentially put their tuition plans on hold until the tax question was settled.

Michigan was the first state to authorize a program in 1986, and to bring the issue of taxes to light. The Internal Revenue Service had wanted to tax the investment income the state earned on the prepayments, but lost in court.

Additional legislation now pending in Congress would make the programs tax exempt altogether.

“Congress basically stepped in and said, ‘This is a good thing.’ It has grown tremendously as a result,” said Kathy Tyson, research manager for the National Association of State Treasurers in Lexington, Ky.

But are these “pay now, learn later” plans a good investment as well? With the tax issue largely settled and more plans popping up, it’s a question many families faced with soaring college costs have been asking.

Financial advisers, for the most part, give prepaid tuition plans only passing grades. They’re good for families who wouldn’t otherwise save and invest on their own, they say, but the more disciplined investors can probably do better on their own.

Prepaid tuition plans allow parents, and in some cases grandparents, to set aside money, either in a lump sum or monthly installments, based on a child’s age.

For example, under Florida’s 9-year-old plan, the nation’s largest with 337,378 participants and $1.6 billion in assets, the parents of a newborn projected to enroll in college in 2014 would pay either a one-time fee of $5,800, $125 a month for five years or $50 a month until the child graduates.

States invest the pooled money, often in bonds, and guarantee tuition costs will be paid for at any state institution regardless of how much tuition rises by the time the child enrolls.

The annual rate of return for participants, therefore, is the inflation rate of tuition, which has been running between 6 percent and 8 percent at most public schools. (Many states earn higher yields overall, which they keep in a surplus account.)

By contrast, the total return on the Standard & Poor’s stock price index was 23 percent last year alone.

“If you have a family or an individual that has the financial maturity to set aside funds, they’re going to be far better off to have invested that same amount of money in well-managed growth mutual funds,” said Hank Madden, who runs Madden and Associates Financial Consultants in Jacksonville, Fla.

“They might even have money left over to pay for things like books and room and board.”

Trouble is, not everyone has that kind of discipline.

“When it’s left up to a family to put money aside, like in a personal savings account, they don’t,” said Tyson. “A lot of people who do set money aside end up raiding it.”

Tyson admits doing just that. “I was buying Series E (savings) bonds for my two daughters and cashed them in for a down payment on a house,” she said.

Another drawback to state tuition programs, financial experts say, is that they can reduce financial aid. Many plans also carry tight restrictions on how the money can be used. Most don’t cover room and board, books, and fees, although at least one has a room-and-board prepayment plan.

Some programs require students to attend public colleges and universities within the state. In others, students can use the tuition money at any public or private school nationwide. Ohio even allows the plan to be transferred to another family member should the child for whom it was intended decide not to go to college.

In most states, however, if a child decides not to attend college, the parents are out of luck. Many plans only return the contributions - without interest.