Tomorrow's Tuition At Today's Price

My article in the March 2001 Working Money discussed saving for college using US Series EE savings bonds. If you're looking for further options, here's another way to fight rising tuition: Take advantage of state-sponsored prepaid tuition programs.

WHY PAY NOW?

Prepaid tuition programs allow you to lock in future tuition at current rates. Since these programs are sponsored and guaranteed by participating states, they are considered safe investments. This simple strategy will always meet your needs as long as your child attends an institution covered under the program. The greatest benefit is the guarantee that future tuition for participating state schools will be fully paid even if the tuition for those schools rises.

For example, if you purchase 100% of your child's tuition now, you can be assured that when the time comes for your child to enter college, tuition will be fully covered. You don't have to worry about rate of return, inflation, or market volatility; all you have to do is pay for future tuition in today's dollars. Fortunately, the contribution limits for prepaid tuition plans are generous; most states allow over $100,000. And some state programs offer tax benefits at state and local levels, as well as federal income-tax advantages.

If you value the simplicity -- and cost savings -- of paying for your child's future tuition today, prepaid tuition may be right for you, provided you have considered the downside of prepaid tuition programs as well. Your child's eligibility for financial aid is reduced by every dollar the program covers, and school choice -- private or public, in-state or out-of-state -- is limited. In addition, prepaid tuition only covers tuition and some required fees, such as technology fees. You may still end up paying for room and board and optional expenses, especially if there is a residency requirement.

HOW PREPAID TUITION WORKS

Here's an example of how the tuition-prepaying plan works. First, you must have an idea in which state your child will most likely attend college; it will probably be the state you and/or your child reside in. Suppose you open an account for your seven-year-old to attend the state's best public university in 10 years. The current tuition is $9,000 per year. You decide to pay a lump-sum payment for one year of future tuition at today's price -- $9,000. After 10 years, your child is ready to enroll in the best public university in the state. Your prepaid tuition program will pay the tuition for that one year.

Let's say the tuition is $15,000 per year when your child enters college. Because you paid for that first year 10 years ago, you do not have to worry about the increase in tuition. Essentially, your $9,000 investment 10 years ago has yielded $6,000 in gains ($15,000 - $9,000 = $6,000). You will have to pay capital-gains tax on the $6,000, but the good news is that the capital gain of $6,000 is taxed at your child's rate, which should be lower than yours.

Not only that, some programs will pay toward your child's school of choice up to the state tuition level if he or she chooses to attend one that is not covered under the plan.

SOME THINGS TO KEEP IN MIND

Take a close look at your state's prepaid tuition program to determine what it covers. In addition, note the following:

• Tax benefits. Most prepaid tuition plans are exempt from local and state income taxes. In addition, federal income tax is deferred until you redeem your plan benefits. Further, the redeemed benefits of the plan are taxable at the rate of the beneficiary, who in most cases will be a minor. A minor's tax rate will usually be less than yours. One caveat to the tax benefits is that you must use the funds at an accredited, nonprofit college (four-year or two-year) or institution. The college can be public or private as long as it is a nonprofit institution. Failure to do so will result in the tax benefits being forfeited.

• Ownership of account. This aspect can affect taxes as well as decision-making issues. If the money was left in your child's name, there is always the possibility that he or she may not use it for college expenses. Most states give control of the account to the parents, giving them the flexibility to change beneficiaries, if necessary. If the funds are not used, you can take them out of the plan, with varying penalties for different plans. Keep in mind, though, that ownership of account doesn't mean you control the funds. The plan administrator will manage the money.

• Financial aid implications. Some college savings plans will affect your child's eligibility for financial aid. At present, prepaid tuition has a negative effect on your child's eligibility for financial aid. For every dollar covered by prepaid tuition, financial aid eligibility is reduced by a dollar. In contrast, if the money was among the assets of the parents, then 6% -- 35% if the money was in the child's assets -- would count toward your child's contribution in the financial aid calculations.

• Asset accessibility. Liquidity will become more important as your child gets closer to his or her high school graduation. Make sure that your plan allows for the funds to be accessible to you as the time gets closer.

• Time frame. The amount of time remaining before your child starts college can determine what type of investment vehicles you can use. Like most investments, the earlier you start, the better off you are. Since tuition prices increase every year, it would be advantageous to lock in the rates early.

Investing in a prepaid tuition plan is similar to investing in a mutual fund. Either a state agency or an investment company administers the plan for the state. (Contact your state's Department of Education for more information.) There are two ways to purchase prepaid tuition: through a lump-sum payment or through scheduled payments. Figure 1 shows an example of a payment schedule set up in Washington state. Figure 2 shows how much you would end up paying with different payment scenarios, based on the national average.

FIGURE 1: The prepaid tuition program for the state of Washington is sold in units, where 100 units are equivalent to one year's tuition. You can pay in a lump sum or in monthly installments. If you decide to pay in monthly installments, you will be paying slightly more.

FIGURE 2: The total cash paid for each year of tuition for different scenarios. This is only for one year's tuition. Note that you will pay more if you choose a longer payment schedule.

Prepaid tuition is open to all state residents, opening the door for anyone who desires to give the gift of higher education to a child. If you have more than one child heading off to college, you should know that some plans allow for the transfer of the funds between siblings. If an older child receives a full or partial scholarship or decides to pursue other options other than college, you may be able to transfer the plan's beneficiary.

CONCLUSION

Whichever vehicle you choose to fund your child's college expense, keep in mind that time seems to go by faster when you are not prepared. Start early and stick with it. A college education can make the difference between getting ahead and fighting just to stay afloat.

Han Kim can be reached at HKim@Traders.com.

REFERENCES

Kim, Han [2001]. "Saving For College," Working Money, Volume 2: March.