Parents flock to prepaid college plans

This article was originally published by on Friday, Feb. 6, 2009.

The bear market has made 529s that let you pay tomorrow's tuition at today's prices attractive. But they come with strings -- and states might not be able to keep their promises.

By Katherine Reynolds Lewis

If you thought paying for college was hard before last year, talk to some parents who had invested their kids' college cash in the stock market.

The past year's losses have crushed many parents' dreams of saving enough for their children's higher education or even a substantial chunk of that bill.

That's why a growing number of parents are turning to prepaid 529 plans, state-sponsored programs that let you pay today's prices for future tuition. Although some plans require students to attend a state university, most states let you use the money at any accredited higher-ed institution.

"When everything's going well in the markets, people think they can go it alone," said Kathleen McGrath, the director of Pennsylvania's tuition account program bureau. "When things get rocky, that's when they want the safety of the prepaid plan."

Pennsylvania saw 26% more new accounts in the second half of 2008 compared with the same period of 2007. Washington recorded 53% more rollovers into that state's prepaid plan, director Betty Lochner said.

"We are the fastest-growing prepaid tuition plan in the country, and we have been for the past four years," said Susan Martensen, a spokeswoman for Washington's plan. "Families . . . want to have a guarantee to know their money is safe, to use it anywhere in the country."

But there's risk to prepaid plans, too. States invest parents' money somewhere so they'll be able to keep their promises about future tuition. In an economy like the current one, that could fall short. States may close plans to new enrollment or raise prices.

And colleges with tightening budgets may not have a seat for your student in any case.

So read the fine print carefully. Here's what you need to know:

The basics first
Let's step back a bit to explain how 529s work.

A 529 plan provides tax-free growth on money you've put away for college or technical school. You typically open an account in behalf a child or grandchild. You contribute after-tax dollars but pay no additional federal taxes when you withdraw the principal or any gains for qualified expenses. Many states also offer a deduction from state income taxes for contributions up to a specified amount.

There are two basic types of 529 plans. The most common is invested in mutual funds or directly in stocks and bonds, so the assets grow as much -- or as little -- as the market does. (This is the kind of plan I wrote about recently in "The great college savings fiasco.")

The other is a prepaid plan, which ties your returns to the growth in college costs. Basically, you pay tuition at today's price, and your investment "grows" to cover tuition when the student goes to college.

Over the past decade, private colleges' tuition and fees have climbed at an average of 2.4% a year above inflation. The figure is 4.2% a year for public institutions, according to the College Board.

Single-digit returns now look good
People who scorned such low growth a few years ago for the market's greater potential are now taking a second look at the prepaid variety of 529.

Linda Weiland of Bethel Park, Pa., had thought stock investments would cover college for her three teenagers.

"A $15,000 or $16,000 loss is a year's worth of tuition," Weiland said. "That got my attention."

She put $10,000 into Pennsylvania's prepaid 529 plan for her daughter, 17, and is adding $200 a month. This year she plans to put another $10,000 into accounts for her 15-year-old twin boys.

"I'm hoping to do as much as I possibly can," Weiland said. "I certainly will encourage all of them to work, as I worked in college, to offset some of the living expense (and) car expense. They'll have to do their share."

Prepaid versus investment plan
Prepaid plans, also called guaranteed tuition plans, were the only type of college-savings plan states offered in the late 1980s. But when states introduced 529 investment plans about a decade ago, parents started pouring money into those accounts instead.

In December 1999, prepaid plans held $4.6 billion in assets among 920,000 accounts, compared with investment plans' $1.1 billion in assets among 200,000 accounts, according to data from the College Savings Plans Network. By June 2008, the $17 billion in prepaid assets, among 2.3 million accounts, was dwarfed by the $111 billion in investment plan assets, among 8.9 million accounts.

"There's a core group of families that are always going to be looking at the less-risky investments," said Chris Hunter, the associate director at the network. "More people focus on it in today's financial markets than when times are good."

Prepaid plans come in different flavors
Each state's plan rules are unique, so it's important to research the options available to you.

"There's a pretty wide variation in the plans; you really have to understand the details of the particular plan," said Joseph Hurley, the founder of

States structure their prepaid plans in two basic ways. One is a contract plan, which obligates the plan to pay for anywhere from one semester to five years at an in-state university. If your child isn't accepted or chooses to attend another institution, the contract specifies how much of your money you'll get back. That can be anything from just your contributions to your contributions plus interest at a specified rate.

The other is a unit plan, which allows you to purchase units of tuition that rise in value based on the increase in tuition at a given set of universities. In Pennsylvania, for instance, accounts can be linked to any of five tuition indexes, from state community colleges to Ivy League schools.

That doesn't mean the Ivy League index offers the most value. In fact, Pennsylvania's McGrath said, although private and Ivy League colleges are the most expensive overall, their tuition growth tends to be more modest than some of the state-related institutions such as Temple or Lincoln University.

"With the unit type, it doesn't matter where your child ends up going to college; you'll get the same value," Hurley said. "With the contract type, you'll get the most value if your child ends up going to the most expensive public institution in the state."

The states with contract plans open to new investors are Alabama, Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada and Virginia. The states with open unit plans are Pennsylvania, Tennessee, Texas and Washington, according to

You generally have to live in a state to join its prepaid plan. If you don't, you can consider the Independent 529 Plan, a contract plan sponsored by a consortium of more than 270 colleges and universities. The prepaid plans in Alabama and Massachusetts are open to nonresidents, and if you're an alum of a Nevada college, you can enroll in that state's prepaid plan. But you wouldn't get any state tax benefit, and you'd be piling up credits that would probably be most valuable if your child attended a school in the state sponsoring the plan.

Most importantly, some plans are backed by the full faith and credit of the state, just like a government bond. Others rely exclusively on the plan assets or a legislative appropriation.

The catch: What if states run out of money?
That's where the potential trouble arises. States invest the money they get from parents in order to cover future college costs. If the market tanks, they run into shortfalls.

"If you have a market that's down 40% to 50% . . . the state would have to step up and make up the difference," said Mississippi Rep. Cecil Brown, D-Jackson, the chairman of his state's House Education Committee.

Mississippi's prepaid plan has an unfunded liability of about $45 million, a manageable amount, Brown said. But if that figure grows, the plan might need to be revised.

"I'm not sure the taxpayers are going to be willing to pay for someone else's college education, so it's something we're going to have to keep an eye on," Brown said.

Already, some states have introduced fees or premiums that new investors pay to make up the difference between investment returns and tuition growth. A handful of states, including Colorado, Kentucky, Ohio, South Carolina and West Virginia, closed their prepaid plans to new accounts in past years.

In the extreme, states could default on debt obligations, but that's rare.

Moreover, there's no guarantee that your child will get into a state university or that the quality of the education will remain high, given increasingly tight public budgets.

So before you open a prepaid 529 plan, make sure you fully understand how it works under different scenarios.

There may be other catches as well. Some plans require you to purchase an entire quarter or semester at a time; that can mean a big lump sum or a loan with finance charges. Others allow transactions in any dollar amount above a minimum.

It's important to note, too, that parents should first save for their retirements, including opening a Roth individual retirement account, if eligible, before turning to college savings. For one, 529 accounts are treated as a parental asset for purposes of financial aid, unlike retirement accounts. The more you save, the less aid you may get. And nobody will give you a loan for your golden years, whereas your children will likely be able to borrow for college. (Read "6 reasons not to save for college" for more on this.)

Of course, those strings and risks may seem small compared with the reality of today's bear market. But before you leap, check the fine print.

Questions to ask about a prepaid 529 plan:

Is the plan a unit or contract type?

May I invest any amount of money, or do I have to purchase an entire semester at a time?

In a contract plan, if I choose to pay tuition over many years, what is the effective interest rate I'll be charged for stretching out contributions?

Is there a premium or extra fee charged beyond current tuition rates?

How can I use the money in the account if my child doesn't attend an in-state university?

Once I peg my returns to a tuition index, can I change my choice later?

Is the plan backed by fund assets (OK), a legislative guarantee (better) or the full faith and credit of the state (best?

Has my state pledged to keep tuition increases below a certain level?
Katherine Reynolds Lewis is considering opening a prepaid 529 plan since losing money in 529 investment-type plans for her three children.