Pros And Cons Of Prepaid College Tuition Plans

Prepaid tuition plans are a type of 529 plan that allows you to set aside money now for your child’s college education. Prepaid plans allow parents to prepay tuition at current tuition costs, which can save them money in the long run. But these plans are also far more restrictive than 529 college savings plans, which can make them less appealing if you aren’t completely certain about where your child will attend college.

How do prepaid tuition plans work?

A prepaid tuition plan is a college savings plan that allows you to pay for future college tuition at today’s rate. You can purchase units or credits, either in a lump-sum payment or in regular installments.

Once your child is ready to attend school, the funds are available to pay for eligible costs. The units or credits you purchase cover tuition and fees, but not other expenses like room and board, supplies or equipment.

These plans are typically sponsored by state governments, and they’re offered only to residents of that state. But in some cases, they’re operated directly by private organizations. After you purchase the credits, the plan administrator will invest the money, though your payout is still guaranteed based on current in-state tuition costs.

Also, as with traditional 529 college savings plans, earnings in a prepaid tuition plan grow tax-free, and you won’t pay any taxes on withdrawals as long as they’re used for qualified educational expenses. If you use the money for ineligible expenses, your earnings may be subject to taxes and a 10 percent penalty.

If your child receives scholarships or chooses not to attend college, you can transfer the credits to another child in your family.

Prepaid tuition plan vs. college savings plan

There are two types of 529 plans — prepaid tuition plans and college savings plans, also called education savings plans. A prepaid tuition plan allows the saver to purchase credits or units at the current price that will cover tuition in the future. College savings plans allow savers to open an investment account to save for the educational future of a beneficiary.

There are a few key differences between the two types of plans.

Key benefits of prepaid tuition plans

There are several reasons to consider using a prepaid tuition plan instead of other forms of college savings plans.

Protection against tuition inflation

The primary purpose of a prepaid tuition plan is to avoid tuition inflation. According to a report by the Manhattan Institute, the average net cost of a four-year public college has grown 81 percent beyond inflation over the last decade. What’s more, those increases weren’t matched by scholarships and other forms of financial aid.

With a prepaid tuition plan, you may have more peace of mind knowing that your child’s education is paid for, regardless of the economic factors surrounding tuition inflation.

High contribution limits

One of the drawbacks of 529 plan alternatives is that they limit your ability to save each year. As of 2024, for instance, you can save only $2,000 per student per year with a Coverdell education savings account (ESA). With a prepaid tuition plan, however, you can pay enough to purchase all of the credits you need.

Tax benefits

Many states offer tax breaks to taxpayers who contribute to 529 plans, including prepaid tuition plans. These breaks can come in the form of a tax deduction or a credit, depending on where you live.

Additionally, as long as you use the money for qualified expenses, all investment gains made in the account are tax-free.

Avoiding student loans

Attending college is expensive: More than half of college students take out student loans to pay. A major benefit of prepaid tuition plans is that they can help your child avoid or minimize their need to take out federal or private student loans to pay for school.

After all, even if they secured the best student loan rates, it could add up to thousands of dollars in interest over the life of the loan — which could make it harder for them to achieve their future financial goals.

Key drawbacks of prepaid tuition plans

While prepaid tuition plansoffer clear advantages, there are also some significant drawbacks that could make it less attractive.

Inflexibility with school choices

The terms of these plans are typically based on in-state tuition at one of the state’s public colleges. So if your child wants to go out of state or choose a private college instead, you’ll have to pay the difference between the actual costs and what you have in your prepaid tuition plan account.

Additionally, if your child chooses a school that isn’t covered by the plan, you may use only your original principal balance — what you paid into the plan — without any of the investment gains.

Limitations with eligible expenses

Unlike a traditional 529 college savings plan, a prepaid tuition plan doesn’t allow you to use your funds to pay for things like room and board, books, supplies, equipment and special needs equipment. So while tuition is covered, you may want to look for other ways to save to make sure that those additional expenses are also taken care of.

If you end up using your prepaid tuition plan funds for ineligible expenses, your withdrawals may be taxed, and you may be subject to a 10 percent penalty.

No control over your contributions

Once you’ve purchased the credits, you don’t have any control over how those contributions are invested. Instead, you’ll have to rely on the investment managers that work for your state, and you’ll also be reliant on the state’s funds, which cover the difference if the investment performance isn’t enough to cover the inflation of tuition prices.

In the past, some states have closed their prepaid tuition plans to new enrollees and have even closed down entirely because of concerns about funding.

Who prepaid tuition plans are best for

The pros and cons of prepaid tuition plans may give you a good idea of whether they’re right for you. But if you’re still not sure, here are some situations where a prepaid tuition plan could be useful:

• You’re confident that your child will attend an eligible university in your state.
• You don’t want your education savings tied to the stock market — funds are guaranteed as long as the state’s funding is secure.
• You don’t want to deal with the burden of selecting long-term investments for your or your child’s education savings.

As you consider whether a prepaid tuition plan is right for you, it’s important to also consider some alternatives. For starters, opening a 529 college savings plan provides many of the same tax advantages but is more flexible in terms of your child’s school of choice and the expenses the plan covers. You’ll also be able to direct how your funds are invested.

If you don’t plan on contributing more than $2,000 per year, a Coverdell ESA may also be a good tax-advantaged option.

Finally, if you want to avoid being restricted to certain expenses, which is an issue with 529 and Coverdell plans, you may consider a taxable brokerage account. You won’t get any upfront or long-term tax breaks, but it can give you the flexibility to use your funds however you please without penalty.

Who is not a good fit for prepaid tuition plans?

• Students who may want to attend an out-of-state college, as prepaid plans are typically limited to in-state, public schools.
• Individuals who may change their choice of schools, as not all schools are included in the prepaid tuition program.
• Savers who need an option that also allows using the money for room, board and book expenses.
• Those who want control over how the money being saved is invested.

What states offer prepaid tuition plans?

All 50 states and the District of Columbia offer at least one type of 529 savings plan. Fewer states offer prepaid tuition plans specifically:

• States with prepaid tuition plans

  • Florida.
  • Maryland.
  • Massachusetts.
  • Michigan.
  • Mississippi.
  • Nevada.
  • Pennsylvania.
  • Texas.
  • Washington.

You can find more details about prepaid tuition plans and other 529 savings plans on each state’s college savings plan website.

Bottom line

Prepaid tuition plans offer a valuable option to get ahead of inflating college tuition costs. However, these plans only cover the costs of tuition and mandatory fees and the saver and beneficiary must live in-state, all of which can be too limiting for some prospective college students. Before opening a plan, be sure to review all of the limitations and understand how this approach stacks up against other 529 plans.