What Is a Prepaid Tuition Program?

A prepaid tuition program refers to one of two major types of 529 plans. The program allows donors to provide all or part of a student's tuition for college or university. The amount paid is guaranteed to grow at the same rate as college tuition, regardless of its rate of growth over time. Prepaid tuition programs are primarily for students who plan to go to an in-state college or university and only cover the cost of tuition.

Key Takeaways

  • A prepaid tuition program is a type of 529 plan that allows donors to provide all or part of a student's tuition for college or university.
  • The amount paid is guaranteed to grow at the same rate as college tuition, regardless of its rate of growth over time.
  • Tuition payments can be made either in a lump sum or through an approved installment plan.
  • Prepaid tuition programs are only offered in 12 states and only allow beneficiaries to attend in-state institutions.

Understanding Prepaid Tuition Programs

Prepaid tuition plans allow plan holders to prepay for tuition costs at qualified schools at today's rates. The program allows account owners—parents, grandparents, and others—to manage future tuition costs at private and public colleges and universities. This means it is a way to pay the cost of tomorrow’s inflated college tuition at current costs. So if the cost of tuition at a specific college doubles within three years, then the amount of prepaid tuition will pay a proportionate amount of tuition at the time of payment.

Because the cost of tuition is increasing faster than the rate of inflation, the rate of return on these plans is generally greater than that of guaranteed instruments such as bonds or certificates of deposit (CDs). But these plans are also guaranteed by the financial backing power of each state.

Tuition payments can be made either in a lump sum or through an approved installment plan. While most plans cater to undergraduate study, some options allow prepaid tuition plans to be applied to graduate study as well. Costs covered by these programs generally apply only to the cost of tuition, so other expenses such as room and board, health care costs, other fees, and materials are not covered.

Special Considerations

Most prepaid plans are guaranteed by the state in which they're administered, so plan holders can be sure their investment will keep up with inflation. Although they're a great way to hedge against the cost of rising tuition, there are actually very few states that have prepaid tuition programs in place. In fact, there are only 12 states that allow residents to save up using this program: Alaska, Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington. Since they are only available to those living in the state, this means the plan's beneficiary must attend an in-state university.

Only 12 states offer residents prepaid tuition programs.

Prepaid Tuition Program vs. 529 College Savings Plan

As noted above, the prepaid tuition program is one type of 529 plan. The other kind is the college savings plan. Both are tax-advantaged programs that allow an account holder to save for a beneficiary's education expenses by choosing a suitable investment portfolio.

Unlike the prepaid tuition option, a college savings plan allows you to cover costs beyond tuition. Qualified expenses can include course materials, supplies, books, registration fees, and even room and board in some cases.

Withdrawing from a college savings plan is tax-free at the federal level. These accounts previously only allowed withdrawals for post-secondary education expenses. But the Tax Cuts and Jobs Act of 2017, the tax reform bill passed by President Donald Trump, expanded these rules. Parents and grandparents can now use the plans to pay for a beneficiary's annual tuition for K to 12 education at public, private, or religious schools. The Setting Up Every Community for Retirement Enhancement Act (SECURE) further expanded these rules after it was signed into law in December 2019. Plan holders can now use their accounts to withdraw a lifetime maximum to pay down $10,000 of qualified student debt. They can also make tax-free withdrawals to pay for tuition and related expenses for a beneficiary's apprenticeship program. The apprenticeship must be approved by the Department of Labor.

Advantages and Disadvantages of a Prepaid Tuition Program

As with any investment vehicle, there are both advantages and disadvantages to putting your money into a prepaid tuition program.

Advantages

The first, and obvious, advantage is that the prepaid tuition program acts as a hedge against inflation. Taking part in this kind of program guarantees that the money paid will cover the cost of tuition no matter how much it rises over time. Plan holders can also transfer the funds to a younger child or grandchild if the original beneficiary chooses not to go to college, or if they decide to go to an out-of-state institution.

Disadvantages

Prepaid tuition programs can be somewhat restrictive in how they can be used. First, your beneficiary must attend an in-state institution, which means they're limited in where they can go. If they want to go to another school out of state, you can get your money back, but you lose out on any of the growth you've earned.

Prepaid tuition programs are also limited in how you can use them. As noted above, you can only use them to pay for tuition, but 529 college savings plans offer a wider range of options. With the latter, plan holders can pay for education-related expenses including books, materials, and other fees, and, in some cases, room and board.