Personal Finance Essentials
Cautions About Tuition Prepayment Plans
Tuition Prepayment Plans Sound Like a Sure Thing
Read the Fine Print First
What These Plans Promise – and What They Don’t Deliver
More than half of states offer programs that allow parents to lock in future tuition at today’s rates. The premise is appealing: pay now, and the tuition is covered no matter what it costs when your child enrolls. But the fine print tells a different story.
These plans cover tuition only – not room and board, which accounts for 40% to 60% of the actual cost of college. They do not guarantee your child will be accepted to the school. If your child is not accepted, or decides to attend a different school or no school at all, the refund policies are often severely limited. In many programs, the state simply returns your contributions with little or no interest. If you cancel participation for any reason before the child turns 18, you may receive your investment back with no return at all – meaning you’ve effectively given an interest-free loan to the state for years.
The Tax Liability You May Not Expect
Under current tax law, tuition prepayment plans can generate a significant tax liability at the moment of use. Here is how it works: if you prepay $10,000 today, and the actual cost of tuition at the time your child enrolls is $50,000, the $40,000 difference is treated as taxable income in the year your child starts college. So, while you may have paid for college in advance, you’ll also need to send a check to the IRS at the same time your child begins their studies.
Additionally, those enrolled in tuition prepayment plans are prohibited from contributing to certain other tax-advantaged college savings accounts, and may be disqualified from using education tax credits that would otherwise offer better tax benefits. The restrictions compound each other in ways that are difficult to untangle.
A Track Record of Problems
The financial stability of state prepayment programs has proven inconsistent. Colorado canceled its prepayment program entirely, returning all contributions to parents when it was unable to keep pace with rising tuition costs. Several other states, including Alabama, South Carolina and Tennessee, have admitted their programs are significantly underfunded and at risk of being unable to honor their commitments. Some states have increased the cost of participation by as much as 15% and added new fees. In addition, securities regulators have pursued a number of enforcement actions against financial firms for improperly recommending 529 products – including prepayment programs – to consumers for whom the products were not suitable. Given these risks, investing in a well-chosen 529 College Savings Plan – where you maintain control over the assets – is a substantially more reliable approach.
