Prepaid Tuition or 529 College Savings Plan: Which Is Best?

Tax Planning

In the late 1970s, a student at a private college paid the modern equivalent of $17,680 per year to attend a private college. If that student went to a public college, total costs were just $8,250 per year. Fast forward 30 years, and those costs had risen to $38,720 and $16,460. Now jump to just a few years ago, when a student at a private college or university paid $48,510 and one at a public college paid $21,370 per year. Those figures represent about a 25% increase from just ten years prior.

Now imagine your young child or grandchild. By the time they walk across the stage to receive their college diploma, what costs will they have faced? Will they be burdened by a mountain of student loan debt before they even start their career?

Chances are that you have thought of this already, and you are searching for ways to avoid that outcome and ease your child or grandchild’s way into adulthood. Two options that are available for parents, and grandparents who want to help with college, are contributions to a prepaid tuition plan or 529 college savings plan. What is the difference, and which one is better for your family’s needs?

Prepaid tuition plans are actually a type of 529 plan (named for section 529 of the Internal Revenue Code), but for the sake of clarity in this post, we’ll use the term “529 plan” exclusively to refer to 529 college savings plan.

Pros and Cons of Prepaid Tuition

What is a prepaid tuition plan? In essence, it is an opportunity for families to “lock in” tuition at an in-state public college at current rates. Considering how quickly the cost of college tuition is rising, that sounds like a great investment, and it can be—but there are important limitations.

The first one is right in the name: these are tuition plans; don’t forget that other college costs, such as room, board, fees, books, etc. continue to rise as well and are not locked in by participation in a prepaid tuition plan.

Michigan is one of 16 states that still offers a prepaid tuition plan.

And because the cost of tuition has increased at a faster rate than originally anticipated, many state plans have been unable to keep up. Some states have been forced to abandon their plans or require parents to pay more for tuition than they originally would have had to. Michigan is one of 16 states that still offers a prepaid tuition plan. States which have ended theirs returned parents’ investments in the plans with a bit of interest. Parents who were expecting to have prepaid tuition for their children suddenly had to figure out how they were going to pay for college, now only a short time away.

It may be hard to imagine, as you watch your baby all decked out in attire from your alma mater, that they would ever want to go to college somewhere else. But a prepaid tuition plan doesn’t just lock in tuition rates. It also locks your child into going to an in-state public college if you don’t want to lose your investment. Furthermore, if you move out of state between now and when your child attends college, they will still have to return to college in Michigan to take advantage of the prepaid tuition plan—only then, they will have to pay out-of-state tuition rates.

Pros and Cons of 529 College Savings Plans

529 college savings plans allow parents, grandparents, and others to contribute to an investment account in which earnings grow tax-free, and withdrawals are tax-free when used to pay for qualified education expenses. Your account may not increase in value enough to fully cover the tuition that a prepaid tuition plan would have paid for. But there are other advantages that make up for that.

For one thing, a 529 college savings plan is much more flexible than a prepaid tuition plan. Withdrawals can be used to pay for room and board, fees, books, and other expenses in addition to tuition. The funds can be used at any college or university, public or private, in-state or out-of-state. If the child for whom the plan was created gets a full-ride scholarship or decides to go into the military instead of college? No worries. A sibling or other family member can use the funds. What’s more, up to $10,000 per year can be used toward qualified expenses for K-12 education.

529 college savings plans are typically easy to open, and affordable to contribute to: in Michigan you can open an account with just $25 per investment option, or choose to have as little as $15 per pay period directly deposited into the account from your pay.

Because 529 plans are assets considered to be held by a parent or grandparent, they have a limited impact on financial aid, which only considers parents’ and children’s assets; an account owned by a grandparent may not affect financial aid at all.

Last but not least, your contributions to a 529 plan could have a positive impact on your own estate planning. Contributions could qualify for the annual gift tax exclusion of $30,000 per year for married couples (or $15,000 for single filers). In addition, you can choose to make five years’ worth of gifts at one time. And unlike most assets of which you retain control, a 529 college savings plan removes your contributions from your taxable estate.

In general, most people find that the flexibility and other benefits of a 529 college savings plan are a better choice than the limited advantages and restrictions of a prepaid college tuition plan. If you have more questions about prepaid tuition and 529 savings plans, we invite you to contact our law office for a consultation.

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