John J. Diak, CFP®
Consider Prepaid Tuition Plans for College Savings
If you’re currently investing for your children’s college education or are planning to do so in the near future, you may want to consider a state-sponsored prepaid tuition plan. Generally speaking, these plans, which are now available in many states, allow you to pay tomorrow’s tuition bills at today’s tuition rates. Also, they allow tax-free withdrawals on earnings if the money is used to pay for qualified education expenses.
Since these plans work, in part, as insurance against rising college costs, there is some degree of speculation involved. Parents come out ahead if the tuition costs rise faster than the average and would do worse if college costs did not rise as fast. Historically, tuition costs have risen, keeping pace with inflation and sometimes outpacing the inflation rate. The other hidden benefit is that grandparents and other relatives -- who may be unsure as to what they should buy as gifts -- can also contribute to the plan.
Despite their benefits, these plans are not for everyone. That’s because returns under such plans may not stack up to returns you may receive in other investments such as stocks -- especially if your child has five or more years before starting college. However, if you are like many parents and did not start thinking seriously about investing for college until your child entered high school, stock investing may not be the best option due to your relatively short time frame before you will need the money.
Keep in mind that each state’s plan is different and has its own sets of benefits and trade-offs.
For parents planning for their children's college education, there are several investment options to consider. One option that seems appealing is state-sponsored prepaid tuition plans available in several states. These plans allow parents to pay today's tuition rates with the assurance that the child will have the money to go to college when the time comes. They also allow participants to defer paying federal income tax on earnings until the money is withdrawn for college.
These plans sound very attractive because of their guarantee as well as relative simplicity. Prepaid tuition plans differ from college savings plans that seek higher returns not tied to the increase in tuition. College savings plans do offer the potential for higher returns than the rate of tuition inflation, but there is a risk that your investment could lose value.
How Do the Plans Work?
Each state's plan works a bit differently, and the newer plans offer more flexibility. Essentially these plans allow parents (and relatives) to "buy" tuition for the child at a fixed price. You either pay in full or pay in installments and you are guaranteed that your investment will keep pace with rising college costs. Depending on the number of years you have until your child first enters college, your cost may vary.
Since these plans work in part as insurance against rising college costs, there is some degree of speculation involved. Parents come out ahead if the tuition costs rise faster than the average and would do worse if college costs did not rise as fast. Historically, tuition costs have risen, keeping pace with inflation and sometimes outpacing the inflation rate. The other hidden benefit is that grandparents and other relatives who may be unsure as to what they should buy as gifts can also contribute to the plan.
Questions to Ask
Is it transferable? To whom? When?
What is the enrollment period?
What costs are covered?
Can out-of-state residents participate?
What happens if you stop paying?
What happens if your child goes to private college?
What happens if your child goes to out-of-state college?
What is the tax effect?
Factors to Consider Despite their benefits, these plans are not for everyone. That's because the returns on these plans may not stack up to returns you might receive in other investments such as stocks, especially if your child has five or more years before starting college. However, if you are like many parents and did not start thinking seriously about investing for college until your child entered high school, stock investing may not be the best option due to your relatively short time frame before you will need the money.
One of the most cited drawbacks to these plans is their lack of flexibility. If your child chooses to go to an out-of-state or private college, he or she may receive only some of the benefits. If you want to transfer the amount to a sibling, some plans may disallow it. Even worse, if your child decides not to go to college at all, or for whatever reason you choose to withdraw money for some other expenditure, you may face very strict refund policies. Many plans impose a heavy penalty for withdrawing money for any reason other than college tuition. Although newer plans now offer more flexibility than their earlier counterparts, there are restrictions imposed on how and when you can transfer funds, should your child decide to go to an out-of-state or private college.
Tax Implications Congress has expanded the tax advantages of these plans to include, among other provisions, the addition of room and board to the category of qualifying expenses. Some state plans offer additional tax advantages.
Assets held in prepaid tuition plans are attributed to the account owner, not the beneficiary (student), which results in a lower impact on need-based financial aid. Additionally, parental assets in retirement plans and the net market value of the family's primary residence are not counted as assets for need-based financial aid.
CollegeSure® CDs If your state does not offer prepaid tuition plans, a variable-rate CollegeSure® certificate of deposit (CD) offered by College Savings Bank in Princeton, New Jersey, may offer a way to make sure the money you set aside today will be able to finance your future tuition bills. CollegeSure CDs offer an annual percentage yield equal to the prior year's college inflation rate as measured by the College Board's Independent College 500® Index. As a result, the value of your assets could increase at the same rate as which college costs are rising. Available in maturities ranging from 1 to 22 years, they pay interest annually each July 31. However, CollegeSure CDs are subject to a maximum interest rate, which is determined in part by the rate in effect the first year you purchased the CD.
Although prepaid plans may not fit every situation's need, they offer benefits to many parents. It may be to your advantage to learn more about these options.
Points to Remember
Prepaid tuition plans allow parents to lock in a tuition rate and begin paying the cost of college today.
If college is still a long-term consideration, parents may get a better rate of return by investing in stocks or a state-sponsored college savings plan that seeks higher returns.
Many plans do not allow for account transfers or payments to out-of-state colleges. Withdrawal of funds for anything other than tuition can result in substantial penalties.
Assets are attributed to the account owner, not the beneficiary, resulting in a lower impact on need-based financial aid.
Parents can also purchase CDs that pay an interest rate linked to the rate of inflation for college costs.
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