Parents flock to prepaid college plans

By Katherine Reynolds Lewis

If you thought paying for college was hard before last year, talk to some parents who had invested their kids' college cash in the stock market.

The past year's losses have crushed many parents' dreams of saving enough for their children's higher education or even a substantial chunk of that bill.

That's why a growing number of parents are turning to prepaid 529 plans, state-sponsored programs that let you pay today's prices for future tuition. Although some plans require students to attend a state university, most states let you use the money at any accredited higher-ed institution.

"When everything's going well in the markets, people think they can go it alone," said Kathleen McGrath, the director of Pennsylvania's tuition account program bureau. "When things get rocky, that's when they want the safety of the prepaid plan."

Pennsylvania saw 26% more new accounts in the second half of 2008 compared with the same period of 2007. Washington recorded 53% more rollovers into that state's prepaid plan, director Betty Lochner said.

"We are the fastest-growing prepaid tuition plan in the country, and we have been for the past four years," said Susan Martensen, a spokeswoman for Washington's plan. "Families . . . want to have a guarantee to know their money is safe, to use it anywhere in the country."

But there's risk to prepaid plans, too. States invest parents' money somewhere so they'll be able to keep their promises about future tuition. In an economy like the current one, that could fall short. States may close plans to new enrollment or raise prices.

And colleges with tightening budgets may not have a seat for your student in any case.

So read the fine print carefully. Here's what you need to know:

The basics first

Let's step back a bit to explain how 529s work.

A 529 plan provides tax-free growth on money you've put away for college or technical school. You typically open an account in behalf a child or grandchild. You contribute after-tax dollars but pay no additional federal taxes when you withdraw the principal or any gains for qualified expenses. Many states also offer a deduction from state income taxes for contributions up to a specified amount.

There are two basic types of 529 plans. The most common is invested in mutual funds or directly in stocks and bonds, so the assets grow as much -- or as little -- as the market does. (This is the kind of plan I wrote about recently in "The great college savings fiasco.")

The other is a prepaid plan, which ties your returns to the growth in college costs. Basically, you pay tuition at today's price, and your investment "grows" to cover tuition when the student goes to college.

Over the past decade, private colleges' tuition and fees have climbed at an average of 2.4% a year above inflation. The figure is 4.2% a year for public institutions, according to the College Board.

Single-digit returns now look good

People who scorned such low growth a few years ago for the market's greater potential are now taking a second look at the prepaid variety of 529.

Linda Weiland of Bethel Park, Pa., had thought stock investments would cover college for her three teenagers.

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Questions to ask about a prepaid 529 plan:

• Is the plan a unit or contract type?

• May I invest any amount of money, or do I have to purchase an entire semester at a time?

• In a contract plan, if I choose to pay tuition over many years, what is the effective interest rate I'll be charged for stretching out contributions?

• Is there a premium or extra fee charged beyond current tuition rates?

• How can I use the money in the account if my child doesn't attend an in-state university?

• Once I peg my returns to a tuition index, can I change my choice later?

• Is the plan backed by fund assets (OK), a legislative guarantee (better) or the full faith and credit of the state (best)?

• Has my state pledged to keep tuition increases below a certain level?

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"A $15,000 or $16,000 loss is a year's worth of tuition," Weiland said. "That got my attention."

She put $10,000 into Pennsylvania's prepaid 529 plan for her daughter, 17, and is adding $200 a month. This year she plans to put another $10,000 into accounts for her 15-year-old twin boys.

"I'm hoping to do as much as I possibly can," Weiland said. "I certainly will encourage all of them to work, as I worked in college, to offset some of the living expense (and) car expense. They'll have to do their share."

Prepaid versus investment plan

Prepaid plans, also called guaranteed tuition plans, were the only type of college-savings plan states offered in the late 1980s. But when states introduced 529 investment plans about a decade ago, parents started pouring money into those accounts instead.

In December 1999, prepaid plans held $4.6 billion in assets among 920,000 accounts, compared with investment plans' $1.1 billion in assets among 200,000 accounts, according to data from the College Savings Plans Network. By June 2008, the $17 billion in prepaid assets, among 2.3 million accounts, was dwarfed by the $111 billion in investment plan assets, among 8.9 million accounts.

"There's a core group of families that are always going to be looking at the less-risky investments," said Chris Hunter, the associate director at the network. "More people focus on it in today's financial markets than when times are good."

Continued: Plans come in different flavors

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