Five years ago, the story of Section 529 plans might best have been summarized by the following headline: “College Savings Plans Explode in Popularity.” However, in the wake of the current multiple-year bear market, those headlines today might be shortened to “College Savings Plans Explode.”
Sagging Section 529 returns, coupled with soaring tuition, have put prepaid tuition accounts in high demand. With their state-sponsored guarantees that money deposited today will keep pace with increases in post-secondary tuition expenses, prepaid accounts are the antidote to the uncertain feeling consumers associate with college savings and investment plans.
Financial advisors, however, can do a disservice to clients if we allow them to put their money where it “feels” best. Clients going for the supposed safety of prepaid tuition plans should understand their potential pitfalls first.
More prepaid = less financial aid
The effect college savings plan distributions have on financial aid packages is murky. The question usually boils down to the following: “Whose money is it?” If the money is deemed to belong to the parents, about 6 percent is figured to be part of the Expected Family Contribution. If the student owns the proceeds, up to 35 percent can be considered part of the EFC. By contrast, prepaid tuition plans can reduce financial aid on a dollar-for-dollar basis — but the disparity won't necessarily show itself until the EFC calculations. Say your client puts $1,000 into a prepaid tuition plan and $1,000 into a savings plan. Suppose, over 18 years, tuition and the savings account both rise at a rate of 8 percent annually. Either way, the client will have an asset worth about $4,000. Yet even assuming a worst-case scenario (that the savings account will be counted as an asset of the student), the prepaid tuition plan might reduce financial aid by $4,000, while the savings account would knock only about $1,300 off the money offered the student's family.
If clients could put money towards “prepaid tuition, rent, pizza, football tickets, spring break and bail money” plans, then we'd have something hot. But prepaid tuition plans only cover tuition and required fees. Money in savings plans, on the other hand, can be used for a myriad of costs, including room and board.
Senior year is really the last year
Prepaid tuition plans can only be applied to undergraduate studies. Savings plans can be tapped for graduate school expenses also.
No sure thing
Sinking stock fund accounts have spured concerned parents toward the supposed security of prepaid tuition accounts. But guess where money in the prepaid accounts is invested? That's right, in the same equity funds that parents are fleeing. Which is just fine — if the market turns up between now and the time Junior is packing his bags for State U. But all boats rise (and sink) with the tide.
“Bad news, Dad: I got into Harvard.”
Many prepaid plans allow owners to tap the accounts for tuition at private or out-of-state public schools. But the benefit available usually some form of weighted average of the administrating state's resident tuition, which might equal only a fraction of the tuition of the student's school of choice.
If the above drawbacks aren't enough to make a parent think twice about prepaid tuition plans, consider these restrictions to particular states' offerings:
The account must be used by the time a student reaches a certain age — usually 30.
The account owner or beneficiary must be a state resident.
Enrollment periods are limited.
Contribution limits much lower than limits on savings plans.
Enrollment limited to children under a certain age — like 13 or 14.
Despite these negatives, prepaid tuition plans might have a place in your clients' portfolios. The best recommendation could be to make deposits into both types of account. In any case, you'll be able to promise your clients that the return on their investment is about as certain as their childrens' future.
Kevin McKinley is a CFP and vice president of investments at a regional brokerage, and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com