NEW YORK (CNN/Money) - Over the past couple of years 529 college savings plans have gone from relative obscurity to a must-do move for parents putting away for higher education.|
Thanks to a not-so-distant bull market and more tax-friendly treatment, assets in these tax-sheltered investments went from $2.5 billion in the beginning of 2001 to an estimated $10 billion at the end of the year, according to Joe Hurley, CEO of Savingforcollege.com.
But as the stock market struggles to return to last spring's levels and companies' accounting practices are called into question, some parents have considered trading in the opportunity for higher returns for the stability of prepaid tuition plans.
"I have had many conversations with prospective and new account owners indicating that they want something a little more conservative," said Geri Reinardy, chief marketing officer for Colorado's 529 college savings program. "We have had more people in Colorado taking a second look at the prepaid plans."
Hurley said he, too, has observed that investors feel "more protected in prepaid plans" in an uncertain market.
College on layaway
Prepaid tuition plans are nothing new. In fact, it was these plans that paved the way for the tax-friendly 529 savings plans that are now so popular.
With a prepaid plan, you buy education contracts or units at today's prices to be used for tuition some time in the future. College tuition has been rising two to three times faster than the Consumer Price Index since 1980, according to the College Board, and this year tuition rose 7.7 percent at four-year public schools and 5.5 percent at private schools. Your effective rate of return is modest but not bad for an investment that carries little to no risk.
Traditionally, prepaid plans have been sponsored by individual states and designed to pay for tuition at public institutions within that state. Though most prepaid plans are still limited to state residents, these plans have improved quite a bit in recent years, says Hurley.
Many states are now paying a minimum interest rate on prepaid contracts, which guarantees some return even in the unlikely event that tuition prices don't go up. Similarly, some states are not only giving full refunds to participants who pull their money out of the plans, they're paying interest (typically tied to the Consumer Price Index). Typically, there is no penalty for canceling the contract but there is a fee of around $50 to $150.
States also have made it easier to convert their prepaid contracts to tuition at private schools and schools outside of the state. "Our program has always been completely transferable," said Colorado's Reinardy. "Even though the price is based on Colorado public schools, it can be used for any higher education expense at any kind of school."
Private schools get in on the act
At the same time states have been improving their prepaid plans, private schools have been given the green light to offer their own such deals. Under the 2001 Tax Relief Act, withdrawals from a private school's prepaid plan will also be exempt from federal taxes as of 2004. (Prior to this year, you would have been taxed on the increased value of a tuition contract from the date you bought it to the date you redeemed it.)
So far, more than 280 private schools, ranging from tiny liberal arts schools like Ripon College in Wisconsin to well-known universities like Stanford and Yale, have joined a consortium of schools called Tuition Plan. As early as the end of the summer, parents will be able to buy prepaid contracts good for tuition at any of the member schools.
What if your child does not get into any of the schools in the network? "To any of the 284? We check you for a pulse," quipped Douglas Brown, who is president and CEO of the plan, adding that you can get a full refund with interest.
The plan currently is awaiting SEC and IRS approval, but you can call 877-874-0740 for information in the meantime.
Worth it for some
If you believe in the stock market's ability to produce decent returns over the long run, you're probably still better off in a 529 savings plan, where you can choose more aggressive investments while your children are young and ease off as they get closer to college.
But if you're extremely risk averse, you may find that what you lose in potential returns from a savings plan you gain in piece of mind through its prepaid cousin.
"If my kids were going into college tomorrow, I would certainly consider putting money into a prepaid plan because I wouldn't want the market risk. If my kids were five or six years old, I'd put it in a savings plan, but I'm not averse to risk," said Ray Loewe, president of College Money.
The IRS treats 529 prepaid plans no differently than 529 savings plans. That means that earnings are exempt from federal income taxes, while in many states contributions are tax deductible. That pushes your effective rate of return up substantially.
Not financial aid friendly
One area where the prepaid plans differ greatly from the savings plans is in how they're treated at the financial aid office. Before 529 withdrawals were made except from federal income taxes, withdrawals from 529 savings plans were treated as family income, which reduced financial aid by about 5 or 6 percent. Now that the withdrawals won't be noted on income tax, 529 savings may have no negative effect on financial aid.
Prepaid plans are a different story. Money held in a prepaid plan is considered the student's resource and reduces financial aid dollar for dollar, says Loewe. If you are planning on getting any kind of financial aid, you should probably skip the prepaid plan and opt for the savings plan instead.
If you're still interested in a prepaid plan after you consider the modest returns and effects on financial aid, you'll want to note every detail of the plan, as they vary greatly. To see how different plans compare click here.