Pay Now, Study Later

Suddenly, earning 8% on tuition savings looks smart

With an average return of about 5% a year, state-sponsored, prepaid college savings plans that guarantee your child's tuition weren't very appealing during the bull market. But after two years in which college accounts have been hammered, parents are taking another look. When you consider that the average state university tuition rose about 8% from 2001 to 2002--and that more increases are likely because of state budget woes--locking in today's costs years before your child enrolls seems like a good deal.

Because they are guaranteed to keep pace with increases in tuition, these plans give you some peace of mind. You make payments based on your child's age--and that's it. The state invests the money and covers your tuition bill when it comes due. Enrollment in the country's 20 prepaid programs rose over 20% in each of the past two years. And thanks to recent tax law changes that let private schools offer prepaids as well, a network of 284 private colleges, called the Tuition Plan Consortium, plans to enter the market this year.

These plans are not for everyone. If you're comfortable with equity investing, the newer breed of Section 529 college-savings plans have the potential to earn more. And they allow your child to qualify for more financial aid than a prepaid allows. Plus, if you use the money for purposes other than college, many prepaids impose bigger penalties than 529 plans.

Still interested? Here's how prepaids work. Suppose you're a Maryland resident with an infant. To pay for a year of tuition, you deposit $4,825, which is below the average $5,250 yearly tuition at a Maryland public college today. You pay more to enroll an older child, since the money has less time to grow (table). If Maryland's tuition costs hit its own forecasts, the bill for your baby's freshman year will be $15,412. That's like earning an average annual return of 6.7%. The plan sends a check to the child's school, whether or not it's a Maryland state school.

There are limits to how much you can shop around for a prepaid. While the 529 stock-based plans are open to everyone, all but three prepaids--Alabama's, Colorado's, and Massachusetts'--require the beneficiary or account owner to be a resident of the plan's sponsor state.

In response to the 529 plans, prepaids have become more flexible. Some states allow you to switch to a market-oriented 529 plan without penalty. That might make sense if the bull market returns or you think you're going to need financial aid. (For every dollar you have in a prepaid, you lose $1 in financial aid, vs. just 6 cents for every $1 in a 529.) And while many prepaids cover only tuition and related fees, a growing number allow savings for room and board, too.

Like 529 savings plans, prepaids are exempt from federal taxes. Although most receive the same state tax benefits as 529s, there are exceptions. Illinois allows state income tax deductions for 529 contributions but not for investments in prepaids.

To determine if a prepaid makes sense for you, look at the rate of tuition inflation at its sponsor state's public schools. If you don't think you can beat that with a 529 savings plan, a prepaid may be a better choice.

Next, assess what type of school your child is likely to attend. If a Maryland student opts for a school that isn't covered by the prepaid, such as a private or out-of-state school, Maryland--like most plans--will pay only the average tuition at a Maryland public college.

If you need the money, you can cash out early. But that means paying income tax plus a 10% penalty on earnings. Worse, many plans charge cancellation fees and hand out paltry refunds. Florida returns only contributions, not earnings. The upside: If your child doesn't use the money, you can transfer the account to a relative.

Also, only prepaids with full-faith-and-credit backing of their states are guaranteed. That's something to consider. For now, most plans are in good financial health.

Prepaids have drawbacks. But if tuition inflation continues to rise more than the return on stocks, these plans will continue to gain in popularity.

By Anne Tergesen

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