What is Prepaid Tuition Plan
A prepaid tuition plan is a state-sponsored or a private plan that is designed to allow account owners to pay for tuition in advance of the student’s actual enrollment. There are two types of Prepaid Tuition Plans:
1. Credit based plans
These allow you to purchase a certain percentage of college tuition today that is guaranteed to be equivalent to the same percentage of state college tuition in the future. Each purchase buys a fraction of the tuition at participating schools; the more expensive the school, the smaller the fraction purchased.
2. Contract based plans
These are a contract between the buyer and the plan: the buyer agrees to make one or more specific payments on a specific schedule. Upon completion of the payments, the plan agrees to provide a certain amount of college expense (typically full expense) at the time when the covered child goes to college.
What Are the Tax Benefits of Prepaid Tuition Plan
- Contributions: Not deductible for federal taxes. Some states allow a deduction for contributions on their state tax returns.
- Growth: Earnings are tax-deferred.
- Withdrawals: Most Prepaid Tuition Plans are qualified 529 plans. For these there is no taxation of earnings when the Plan pays for college.
Gift Tax Impact
Contributions to Prepaid Tuition Plans are considered gifts to the beneficiary, and gift tax rules apply. A gift tax tax return must be filed when the total of all gifts from one contributor to the beneficiary exceeds $14,000 in one calendar year (this is the 2013 limit).
Contributors may put up to $70,000 (single) or $140,000 (married) into 529 Savings Plans and qualified 529 Prepaid Tuition Plans without gift tax implications by filing a gift tax tax return (IRS form 709) and applying the contribution “ratably” over a five year period. This “future allocation” does not apply to non-529 style Prepaid Tuition Plans.
Does Prepaid Tuition Plan Have Contribution Limits
Generally there is no annual limit as long as lifetime limit is not breached. There may be a minimum annual contribution.
There might be aggregate maximum lifetime limit which will vary by plan. It is usually not possible to purchase contracts that will buy more than eight, nine, or ten semester’s worth of tuition at a state’s public university. Private plans limit accounts size to the cost of four or five years of tuition at the most expensive institution in the plan.
How to Use Prepaid Tuition Plan Funds
Prepaid tuition plans are specifically designed as tuition savings vehicles. However, many consider room and board costs qualified withdrawals.
What are Investment Choices in Prepaid Tuition Plans
If you purchase prepaid tuition plans, you assume the risk that the student will not attend college or a participating college. In this case, return on investment may be low or non-existent.
Can a Prepaid Tuition Plan be Transferred
Most plans mature in a pre-designated year for a specific beneficiary. Some allow intra-family changes in beneficiary, but may require additional “catch-up” contributions if the new beneficiary is a different age than the original beneficiary.
Most remain valid for ten years following the student’s graduation from high school. Some plans stop allowing intra-family transfers after the first withdrawal for the original beneficiary.
Who Controls Prepaid Tuition Plan
Anyone can purchase tuition plans for a beneficiary; some plans allow the owner and beneficiary to be the same person. For most state plans, the owner and/or beneficiary must be a resident of the sponsoring state.
Account owner controls the account at all times. There is no transfer of control to the beneficiary during the lifetime of the account owner.
What if Prepaid Tuition Plan Not Used for Qualified Expenses
The same taxes, penalties, and exceptions that apply to non-qualified withdrawals from a 529 Savings Plan apply to non-qualified payments from qualified Prepaid Tuition Plans.
In addition, funds not used are returned with a pre-determined rate of growth (often inflation plus a small percentage). This may be far less than the rate of inflation at the plan’s participating colleges.
Does Prepaid Tuition Plan Impact Financial Aid
Starting with the 2006/2007 academic year, the financial aid formulas have treated Prepaid Tuition Plans in the same manner as 529 Savings Plans.
What Else Should I Know About Prepaid Tuition Plans
Most Prepaid Tuition Plans are geared to saving for in-state public school educations, or specific participating private colleges, without a guarantee of admission to participating schools. Some are geared toward saving for a specific list of schools, and provide a different rate of return depending on the college the student ultimately attends.
It is important to understand what the plan will pay to non-participating schools before selecting a Prepaid Tuition Plan. The rate of return afforded the Prepaid Tuition Plan owner may be much smaller than expected if the plan is used to pay qualified education expenses at non-participating colleges.
Prepaid Tuition Plans are effectively promises that the Plan will have the resources to pay its obligations to the owner sometime in the future. They invest the payments made by participants and hope to earn enough through these investments to pay future claims. This has proven difficult for many plans, which have taken extreme steps to remain solvent. These steps have included increased fees on participants even on assets invested in the past, and greatly reducing the non-participating school payouts, and the payout value for non-qualified withdrawals, even for long-standing contract owners. There is a unique risk with Prepaid Tuition Plans that the terms of the Plan can change significantly years after the contract is open.
In recent years, Prepaid Tuition Plan pricing has moved from a model where payments were close to payments that a parent of a college student might make, to one where new account owners pay substantially higher prices than existing account owners. Before signing up for a new Prepaid Tuition Plan contract, compare its pricing to the actual tuition costs of participating colleges.