Are Prepaid College Funds the Way to Save for Our Two-Year-Old Son?

If you’ve got a youngster at home, you might be wondering if prepaid college funds are worthwhile or not . I received the following e-mail last week from “L,” a reader who is interested in knowing the best way to start saving for college for their young son:

Here’s part of what she wrote to me:

“529 programs have high fees. Also, they did so poorly last year in returns, I’m not so sure they are the best option anymore.”

“What about the prepaid state plans? We live in Florida, which just approved a 30% increase in tuition costs starting in two years; interestingly, prepaid plans purchased two years ago are NOT protected from this increase (that sucks and IMO, seems to negate the whole purpose of the prepaid plan, right?)”

“Wondering if you are just better off with self-selected stocks, mutual funds, etc., that are managed with diversification toward more-conservative approaches as the child gets closer to college age?”

“L” brings up many good points and questions. Let’s go through it together.

Depending on where you live, a prepaid college tuition plan may be a great start for college savings if you have young children. But you have to be careful. If you buy into one of these plans, you might get some unpleasant surprises too.

What are prepaid college funds?

These are plans offered by 19 states that allow parents to make a lump-sum payment (or even make monthly payments) in order to pay for tuition now and lock in the cost of college.

The big draw is you don’t have to worry about investment returns. When you buy a prepaid plan, you’ve locked in the tuition expense. It doesn’t matter how poorly your investments do, and it doesn’t matter how high tuition rises.

There is the added benefit that the money in this plan is considered an asset of the parents rather than of the student. That helps when it comes to determining financial aid later on and it will be much more pleasant when you are filling out those financial aid forms.

What are the problems with prepaid college funds?

First, the prepaid plan only covers tuition. It won’t cover the full cost of an expensive college education like room and board. Those costs continue to escalate with inflation, so even if you use a prepaid plan, you better keep saving.

Also, if your child goes to private college, private career college or out-of-state college, the plan won’t cover all the costs. Different plans cover this issue differently, so check.

As the father of three, I can tell you that I never would have guessed which schools my kids would have ended up in. That’s why I never paid much attention to these plans, and that decision worked out for us.

Many prepaid tuition plans include a time limit from the date of expected college entrance or high school graduation. Better read that fine print.

Another big negative: not all plans are backed by the state offering them. That means if you buy a plan from a private enterprise, you take the risk that the money may not be there when the child goes to college. And let’s face facts. The way things are going, I’m not sure I even trust the states to live up to all their promises either.

Can the state increase fees?

It depends on the plan. In the Florida case, I did some digging and found that this increase only impacts two of the Florida plans – not all of them. Still, I agree that passing on any increases stinks. The entire reason people participate in these plans is to escape the problem of rising costs. In this case, Florida seems to be passing the buck because they experienced lousy investment returns and higher costs. Again, check your plan’s fine print.

My main beef with the prepaid plan is that you don’t know where your kid is going to go 16 years from now. You really have no idea.

I also don’t like the fact that most of the states offering these plans are struggling. They are all facing losses because of increased cost and lower returns. As a result, they are indeed hiking fees. In most cases, they can’t pass those higher costs on to you, but you must check the details of your plan.

Having said all that, if you know where your child is going to school and you make sure your plan can’t hike the fees, a prepaid tuition plan would be a great way to go.

Now for L’s question about the 529.

Are these the best investments? Well…everybody lost money in 2008 – not just 529 plans. There are a few problems with 529s, but performance isn’t one of them unless you select the wrong investments. These plans give you lots of room to make investment decisions. And the tax benefits these plans provide make them a great option for you too. I’ll be writing more about 529 plans, so stay tuned.

The bottom line is this: You have to be careful with the prepaid plans but they could work for the right person. 529 plans are a fantastic idea too – especially for people with very young Pilgrims at home.

What do you think about prepaid tuition funds?