Paying For The Kid's Sheepskin

With costs rising 6% a year, funding vehicles are gaining popularity

In 1990, the first year their son attended Towson State University in Towson, Md., the Brookses took out a federally guaranteed parent loan of $2,500 at 8.5% to pay for tuition. By the second year, they had a better idea. They used the school's interest-free tuition installment plan. "We liked being able to use our income to make monthly tuition payments instead of taking on debt," says Betty Brooks, a billing supervisor in Baltimore.

Like the Brookses, most parents have two choices for how to pay for their child's college education: going into debt or saving little by little. With tuition costs rising about 6% annually, or twice the inflation rate, the four-year cost for in-state tuition, room and board, transportation, books, and other expenses at a public college is likely to rise from $44,743 in 1997 to $135,375 by 2016, according to T. Rowe Price Associates Inc. Four years at a private school is estimated to jump from $94,416 to $285,665 in the same period.

Recently, college funding vehicles such as installment plans, prepaid tuition programs, savings trusts, and savings bonds have been gaining in popularity. Of course, you could probably earn more investing in mutual funds, stocks, or bonds, although the earnings wouldn't have the same tax advantages as some of these plans. But these programs are designed not so much as investments as vehicles for the risk-averse or the procrastinator to start saving for college. "These plans sell peace of mind," says Kalman Chany, author of The Princeton Review Student Advantage Guide to Paying for College ($18, Random House) and president of Campus Consultants Inc., a student aid consultancy in New York. "Parents know that no matter what, they have some money salted away for tuition."

Most schools offer installment plans, which allow tuition to be paid over several months instead of in two big chunks. This option is best for families who can pay tuition out of cash flow but don't have thousands of dollars tucked away. School-managed plans typically charge an annual enrollment fee of up to $75, depending on whether parents pay by check, credit card, or electronically. Other schools levy a 1% annual finance charge on the balance. Payments are spread over 3 to 12 months for each school year.

Schools that outsource this service to AMS or Knight College Resource Group, among other firms, offer the benefit of insurance to cover costs for the rest of the year in case the parents die. AMS charges an enrollment fee of $50 that includes insurance, while Knight's coverage costs $80 a year on top of a $40 annual fee. "When you compare an installment plan to the alternative of debt, you save a lot of money," says William Hastings, president of AMS in East Providence, R.I.

TODAY'S PRICES. Prepaid tuition plans let parents save well in advance of when their children are ready for college. Born in the mid-1980s as the answer to tuition hikes of 12% to 15% a year, prepaid tuition locks in future costs at today's prices. For instance, you can pay $13,400 today for your newborn to attend four years at Ohio State University in 2014, saving $33,811 of the projected $47,211 cost (assuming 7% annual gains in tuition). Prepayments are made in installments or a lump sum and invested to cover future costs. These plans are best for families with incomes between $30,000 and $80,000 that don't qualify for grants and would need to go into big debt, says Barbara Jennings, executive director of the Ohio Tuition Trust Authority.

The College Savings Bank in Princeton, N.J. (800 888-2723), is the only private institution to offer a national prepaid plan that doesn't restrict school choices. States administer the other programs, which apply to in-state schools. A law signed by President Clinton in August could lead to a boom in state plans. It allows participants in qualified programs to defer payment of federal taxes on the increase in value of the tuition plans and other savings for higher education expenses. Taxes are paid at disbursement at the child's lower tax rate. Prior to August, the Internal Revenue Service rules were unclear.

The state plans were already exempt from state and local taxes. Nine states have prepaid plans (Alabama, Alaska, Florida, Massachusetts, Michigan, Ohio, Pennsylvania, Texas, and Wyoming), five will start in the next year (Colorado, Mississippi, Tennessee, Virginia, Wisconsin), five have legislation pending (California, Minnesota, New Jersey, New York, Oklahoma), and many others are considering programs, according to the College Savings Plans Network.

"WILD CARD." The pay-now, learn-later concept seems to be a good one but is not without flaws. "When you don't take the student into account, it's a wild card," says Diane Rolfsmeyer, a certified financial planner in Lincoln, Neb. For example, what happens if your child isn't accepted to one of the schools included in the plan or decides not to go to college at all? States typically allow the funds to be transferred to family members at no cost, but most refunds come with penalties and without interest.

Say your child isn't keen to go to one of the state schools the plan includes. Most states will transfer the value of the tuition units or credits to any accredited out-of-state school, but sometimes that value is capped. Massachusetts invests in bonds and caps the return at interest equal to the rate of inflation, compounded annually.

Residency, a prerequisite for most plans, is another concern. For example, you live in Pennsylvania and prepay a state plan, then move to Arkansas. When your child matriculates in Pennsylvania, you will have to pay the difference between in-state and out-of-state tuition. Moreover, state prepaid tuition plans, with the exception of Florida, include only tuition and fees. That accounts for an estimated 50% of the total cost of college. Books, room and board, and other expenses are not covered.

Colleges say parents will save money when they avoid tuition hikes, but the savings really depend on what's going on with interest rates, says Chany. If the aftertax cost of borrowing to make a prepayment is less than the tuition increases over the four years, then these plans make sense. But if you're paying a lump sum and the aftertax rate of return on investments is higher than the rate at which tuition is increasing, forget about investing in the plan.

Two other options that can help with the college-saving goal are state savings trusts and savings bonds. The trusts provide tax advantages to people who are saving for college. Indiana, Louisiana, Kentucky, and Utah each have a plan that works a little differently. Louisiana residents, for instance, save amounts they can afford in a professionally managed account. Deposits are state tax-exempt and federally tax-deferred. As an added incentive, account holders receive Louisiana state assistance grants based on income and the amount annually deposited. For example, a family with an adjusted gross income of $25,000 a year can deposit any amount they want and will earn 12% on their deposits at the end of the year.

Kentucky guarantees a minimum rate of return of 4% for money deposited in a special college savings account. The child must be under the age of 15 when parents open the account. All earnings on savings are exempt from state taxes and subjected to deferred federal taxes in the future.

SMART STRATEGY. Some states, such as Illinois, sell college savings bonds at deep discounts to maturity value. Not only does the interest accumulate tax-free but the state pays an additional $20 a year for bonds purchased after 1988. Since the late 1980s, interest earned on Federal EE savings bonds has also been tax-exempt if used for college.

While the returns on savings bonds won't bowl you over, especially if the stock market continues climbing, it's important to diversify your college portfolio. A smart strategy might consist of being aggressive with at least half of your funds while your child is still 14 years or more away from entering college. The remaining portion could be invested in the more conservative savings options that have tax advantages. Once the child is within four years of starting school, begin to pare down the stocks and mutual funds and sock the savings away in safer investments. Later, when the tuition bills start rolling in, you'll get high marks for all your sound planning.

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