School may be out for summer, but most parents find that saving for college education is a year-round job. Today's lesson will deal with the pluses and minuses of prepaid college tuition plans.

Prepaid tuition plans allow families to lock in tomorrow's college tuition costs at today's prices. The plans, now offered in more than 20 states for both public and private colleges, are often limited to state residents and are not marketed by major financial firms. That means interested investors need to research prepaid plans on Web sites created by various states.

"Prepaid tuition plans are generally pretty good," says Rick Bloom, financial adviser at Michigan-based Bloom Asset Management. "But not all plans are the same. It's important to understand the terms so that your child gets all the benefits associated with the plan."

The Pluses

  • Convenience: Most plans make it easy to start with either a lump-sum cash payment or a series of payments over time. Many plans even offer payroll deduction programs or automatic bank account withdrawals. Once the money is added to the account, a professional money manager is responsible for conservatively managing the account until the child is ready to start college.
  • Tax Benefits: The federal government does not tax distributions from these plans as long as the money is used to pay for qualified college costs. One important item to note is that the benefits are restricted to tuition fees, not housing, books or other college-related expenses. Most states also treat the withdrawals as tax-free, although out-of-state students may face different circumstances. And depending on the state in which you reside, a portion of your annual contributions to a plan may be deductible on your state tax return.
  • Rate of Return: Prepaid tuition plans are not designed to trounce the indices, but to grow conservatively. Nevertheless, the rate of return is better than other low-risk investments like certificates of deposit and money markets. They are also indexed to the increase in tuition costs, which rose at about 6% at private colleges and 10.5% at public colleges for the 2004-05 year (according to
  • Control: Most prepaid tuition plans are transferable to other members of the family if the student for whom the fund is intended decides to skip college. Furthermore, unlike custodial accounts, prepaid tuition accounts are set up so that the parent or grandparent funding the account, not the child, maintains control of the account.

The Minuses

  • Rate of Return: Although prepaid funds are professionally managed, they are managed to minimize risk. So many investors might be able to do better themselves if they take the initiative. Prepaid tuition plans are also definitely not for investors looking to make up time because they waited until too late in the game to save for their child's college tuition.
  • Changes in the Law: The current laws governing the tax breaks associated with prepaid tuition plans expire in 2011. Most analysts believe that the tax breaks will be extended, but it is worth keeping in mind that unless Congress makes the current laws permanent, the money your plan account earns will be taxable to your student when he or she withdraws the funds to pay for college. Of course, the student will presumably be at a lower tax bracket.
  • Financial Aid: Your child's financial aid eligibility will be affected. At present, money invested on behalf of a student in a prepaid tuition plan is considered a resource for paying for college, so the funds count dollar-for-dollar toward the ability to pay for college costs.
  • School Choice: Your plan may restrict the institutions that qualify for coverage thereby limiting your child's choice of schools. And certain out-of-state and private colleges may be stingy with coverage rates, which is why we urge investors to read the terms carefully before signing up.

"Education is always going up, so by that measure, prepaid tuition plans are a great idea," says Mary Rinehart, financial adviser at Charlotte, N.C.-based Rinehart & Associates. "But parents should also remember that many of these plans limit their child's choice of schools. And while most parents think they know what's best for their children, sometimes their children have very different ideas when it comes to their futures."