The Pros and Cons of Prepaid Tuition Plans

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Prepaid tuition plans are designed to help families start saving for their children's college expenses, but they may not always be the best choice.

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For the 2018-2019 school year, the average in-state tuition at a public four-year college was $10,230. Just 10 years ago, it was only $7,560 in 2018 dollars. In other words, even after adjusting for inflation, public school tuition has risen 35% in a decade. Meanwhile, overall inflation during that period was just 17% as measured by the Consumer Price Index.

College tuition rates have increased so dramatically in recent years that higher education is now in crisis mode, and the amount of student loan debt considered "seriously delinquent" is now at $166 billion. It's no surprise that parents are planning ahead and seeking out the best ways to save for their children's college expenses.

Many states have responded to this dilemma by offering prepaid tuition plans. These plans are designed to help families start saving for their children's futures, but they may not always be the best choice for college savings. By understanding what these plans are and how they may or may not meet your family's needs, you can make the best decision for your child's future.

What is a prepaid tuition plan?

Prepaid tuition plans allow you to pay for future college credits at today's tuition rates, potentially saving you a significant amount on higher education. Some states offer this in the form of a 529 plan that can be used to cover the costs of in-state tuition and associated fees.

Prepaid plans offer many of the same tax benefits as traditional 529 college savings plans: Your earnings grow tax-free, and your withdrawals won't be taxed if they're spent on qualifying education expenses. But most prepaid tuition plans are only available to residents of the state that offers them, and they place more limitations than traditional 529s on how the money can be spent, making them less flexible. Let's look at some of the pros and cons so you can better weigh your options.

The advantages of prepaid tuition plans

Prepaid tuition plans offer a sense of security, in knowing that you are actively preparing to help your child get ahead in life. There are a few primary benefits of these plans if everything down the road goes as planned.

Locked-in tuition rateTuition is on the rise, and if it continues to skyrocket in the future, you'll be glad you settled on a locked-in rate beforehand. In addition, your investment isn't directly tied to stock fluctuations, so if the market crashes, you will still be able to benefit from that locked-in rate instead of assuming all of the risks of a traditional savings plan.

Flexibility if your child chooses a different collegeEven though prepaid tuition plans are offered by your state, and the rates are generally tied to the current in-state tuition rate of that state's public universities, the funds can typically be transferred to private or out-of-state universities if your child chooses a different path than the one you had planned. Keep in mind that you'll have to pay the difference in tuition using a different source of funds.

No limit on the amount you can saveMost plans don't have a limit on how much you can invest, allowing you to significantly contribute over time.

No investment decisionsYour contributions are pooled with others participating in the program and then automatically places into long-term investments by the fund’s investment managers, meaning you don't have to make any decisions on how your money is invested. This is convenient for some, because there isn't a financial learning curve involved, and it's one less decision that has to be made. Returns will depend on the plan you’ve selected, as each one is managed differently, but for reference: the Maryland Senator Edward J. Kasemeyer Prepaid College Trust had returns of 7.1% at the end of the fiscal year in 2018. Many plans are now guaranteed by the state legislature, meaning that if future tuition increases are higher than the fund’s returns, the state will pay the difference.

Contracted paymentsBy signing a contract, you know exactly how much you will be contributing on a consistent basis. If you aren't great at saving money in general, this extra formality may be the push you need to meet your savings goals.

Ability to transfer funds to a different childIf the intended child chooses a different route, you can transfer the funds to another child and maintain the full growth and benefit of your investment.

The disadvantages of prepaid tuition plans

Although prepaid tuition plans seem straightforward and clearly advantageous, some families may find them more restrictive in the long run. Here are some potential pitfalls that may sway your decision.

Limited options for your childSince the funds can only be used for colleges in the state that administers the plan, your child may feel pressured to explore only nearby schools instead of pursuing a more fitting one in another state.

Plans might not cover out-of-state or private universitiesIf your child chooses to attend somewhere other than an in-state college, you may end up having to pay current tuition rates rather than the old ones you locked in with a prepaid plan. Some state plans, on the other hand, will transfer an amount that’s equal to their current in-state weighted average tuition and fees to the school of your choice. However, if you don’t use the plan at all, in most cases you won't have access to any of the growth of your investment -- defeating the purpose of the prepaid plan.

Limited education costs are coveredOnly tuition and mandatory fees are typically covered by a prepaid plan, whereas alternative college savings plans cover expenses such as books and room and board. These are significant expenses that should be planned for.

You must sign a contractContribution terms vary by plan. Some accept an up-front lump sum, while others offer monthly payment plans. If you decide to stop making payments, you have to actively cancel the contract. This can make you feel guilty. With other college savings plans, you can choose to make contributions whenever you please.

No control over contributionsThe state's prepaid tuition plan chooses how your funds are invested, so you don't get any investment options. Most states hire investment managers who focus on long-term investments that will, in theory, outpace tuition rate increases. If you have a knack for finances and see better investment opportunities, you'll find that your hands are tied and you have no say in the decision.

Dependence on state fundingThere is a chance that your state may not be able to guarantee the funds you've contributed. In other words, if increasing tuition rates outpace the return on your investment, the state might not cover the difference. Some states have closed their plans to new investors or refunded investments due to underfunding concerns.

Others may have difficulty contributingWith a prepaid plan, family and friends may run into barriers when attempting to contribute to your child's account. With other savings plans, supporters can send money directly to the plan for birthdays, holidays, and other special occasions.

Is a prepaid tuition plan right for you?

Prepaid tuition plans have advantages for families who are confident their child will attend an eligible, in-state university and are comfortable with the various plan trade-offs. These plans make it easy for parents to set up the account, make fixed payments, and rest assured that their funds will be available later down the line.

However, if you desire more flexibility and control over your funds, a traditional 529 college savings plan may be more appropriate for your family. You'll be able to select an investment portfolio that reflects your financial goals and give your child more flexibility when selecting their future path. You also have the option to take advantage of both a prepaid tuition plan and a traditional 529 plan in order to cover expenses that won't be covered otherwise.

Plans vary by state, and less than half of states offer a prepaid plan at all. Check with your state to determine what plans may be available to maximize your investment. No matter which plan you choose to move forward with, the earlier you start saving for your children's future, the more you'll set them up for financial success as an adult.