CERTIFIED PUBLIC ACCOUNTANTS AND ADVISORS |
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PRE-PAID TUITION PLANS DESERVE A SECOND LOOK In recent years, state-sponsored prepaid tuition plans have
played second cousin to their younger and wildly popular 529 savings plans.
While nearly every state offers a 529 plan, fewer than 20 offer prepaid plans.
But with college tuition increasing in leaps and bounds, and the stock market in
a slump, prepaid plans are looking attractive to families wanting a
solid-returning, lower-risk college savings vehicle. Prepaid plans and college savings plans fall under the same
section of the federal tax code and share some of the same tax benefits: no
income restrictions on contributors, tax-free growth of earnings and
tax-exemption of earnings as long as they’re spent on qualified education
expenses. But the plans differ significantly in several ways. The primary characteristic of prepaid plans is that they
guarantee, in general, that your investment in the plan today will keep up with
future increases in school tuition. Until recently, only states sponsored
prepaid plans. Now some private colleges offer them. Returns on investments in 529 college savings plans, which
are placed in mutual-fund type accounts, are not guaranteed. On the other hand,
you have the potential of earning more overall than the annual increases in
state tuitions. But two factors are driving renewed attention to pre-paid
plans. First, the decline in the stock market since March 2000 has damaged
returns for college savings plans, just as it has hurt returns for mutual funds.
Worse, many investment experts are predicting market returns in the next 10 to
20 years to average lower than the historical average (around 11 percent). Meanwhile, college tuition increases, which had been
running four to five percent annually in recent years at state schools, have
jumped dramatically. Average tuition costs at four-year public institutions rose
nearly eight percent for the 2001–2002 academic year. More ominously, several
state schools, hit hard by budget cuts from revenue-strapped states, have
already announced tuition increases of 10 to 20 percent for 2002–2003. Prepaid
plans would guarantee that such huge increases would be covered, while investors
in state-run 529 plans can only hope the market will perk up. The investment return on prepaid plans doesn’t precisely
follow the average rate of increase in the state’s public colleges and
universities. It’s a bit more complicated than that. For example, with
programs using “contract” plans in which families buy in a lump sum or a
series of payments a specified number of years of tuition (versus buying
“units” representing a fraction of tuition and fees), you can end up buying
tuition at a discount or at a premium. This depends in part on your child’s
age at the time you join the plan, number of credit hours eventually taken and
which state institution the child ultimately attends. Collegesavings.com gives the example of an Alabama family
buying a contract for their 8th grade child. If the child ultimately
attends the more expensive University at Montevallo, they receive a 7 percent
discount. If the child attends Alabama State University, they pay a 24 percent
premium. Predicting the precise returns upfront is impossible, but
an April 2002 article in the Journal of Financial Planning concluded that
the average annual after-tax return of prepaid tuition plans since 1991, based
on a hypothetical national plan, was 6.3 percent. It returned this with
one-fifth of the risk of the S&P 500. But return isn’t everything. College savings plans offer several advantages over prepaid plans, including
A financial planner who is knowledgeable about your state’s prepaid plan can help you weigh the critical factors of the plan to determine its potential attractiveness compared with other college financing alternatives. August 2002— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLP, a local member in good standing of the FPA. |
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