Using 529 Prepaid Tuition Plans to Save for College

With stock market volatility, how can you be sure that the money you save will grow to the fund you anticipate to pay for your child’s education? You can’t. What you can do, however, is use a savings option that ensures tuition and fees will be covered-in whole or in part. This option is called a prepaid tuition plan.

How it works

Contributions to a 529 prepaid tuition plan buy tuition credits. The value of the contributions increases in tandem with the cost of tuition. For example, you buy one full year’s worth of tuition at your state university for your newborn. When your child attends the school 18 years from now, she will have one full year covered, regardless of what tuition actually costs at that time. Thus, there is no risk to principal; whatever the stock market does, you are assured that your contributions will pay for that amount of tuition you had expected. These plans typically outperform savings you could achieve on your own through CDs and other safe investments.

However, there are some drawbacks to consider:

• Limited school options. Tuition credits usually are restricted to in-state schools and are designed to cover costs at public institutions. There may be insufficient savings for state private colleges and universities or out-of-state schools. Caution: Having a plan is no guarantee or help that a child will be accepted to a particular school.
• Savings are very conservative. If a child is young, so there is a long savings horizon, more funds can probably be accumulated through a 529 savings plan.
• Covered costs are limited. Prepaid tuition plans cover only tuition and fees, compared with savings plans that can also cover room and board, books and other expenses.

States with prepaid tuition plans. Not every state offers this savings option. States with such plans include: Alabama, Colorado, Florida, Illinois, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Ohio, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, Washington, and West Virginia.

Private prepaid tuition plan. There is also a sponsored by a consortium of more than 250 colleges and universities nationwide, including many Ivy League and other prestigious institutions, that offer a separate plan.

Tax breaks

There are not federal tax deductions or credits that can be claimed for contributing to a prepaid tuition plan (there may be state tax breaks for residents). However, earnings grow tax deferred and, when tuition credits are used for the beneficiary’s schooling, there is no tax to you, the contributor, or to the beneficiary.

Caution: Cancellation of participation in the plan and withdrawals are subject not only to substantial penalties imposed by the plan, including loss of principal. There are also a 10% tax penalty, as well as any income tax on earnings excess of your contributions.