Let's break down how prepaid tuition plans work, and how they compare to 529 plans. You can find the prepaid tuition plan in your state in our guide: 529 Plans By State .

It sounds simple - prepay for tuition now, and don't worry about rising costs later. But how do these plans really work?

Prepaid tuition plans were introduced by the IRS, in conjunction with the U.S. Securities and Exchange Commission, at the turn of the millennium in the hopes of helping parents lock down certain tuition rates early on so they won’t have to worry about skyrocketing college costs in the future.

The government is doing its best when it comes to subsidizing tuition fees, but most families are now being forced to look at the option of applying for student loans which might leave post-college individuals struggling to pay their way out of debt for decades.

Tuition and fees are on the rise, and this trend isn’t going to be letting up any time soon. With the rising cost of living in almost all states in the country, most parents with children are beginning to worry about their loved one’s prospects of education and their ability to pay for college.

What Exactly is a Prepaid Tuition Plan?

Prepaid tuition plans are similar to 529 plans, and they essentially work by allowing parents to put away a certain lump sum in a specific account that they can later use to pay for tuition costs, books, and in some cases, even room and board.

These plans are available in 9 states currently, and they are a boon for families who would like the peace of mind in knowing that their children will be able to attend college regardless of the current as well as future financial situation these families and the country may find itself in.

Where to Find The Plans

You can currently find plans in the following states:

Note, plans were previously available in Illinois and Virginia, but they are closed to new enrollment. Existing accounts can still be redeemed, but no further contributions can be made.

Types of Prepaid Tuition Plans:

Unit plans: These let you pay for fractional units that you can then redeem at later time according to the average rates offered by a group of colleges in a certain region. Contract plans: With these, you get to pay for tuition for a number of semesters in a state college, much like you would if you were paying your phone or cable contract. Voucher plans: These are like percentage-off coupons savings where you get to pay a certain percentage of the tuition at chosen colleges.

What’s so great about pre-paid tuition is the fact that anyone can open these accounts for the intended student so long as they are done so within the state that the student resides in.

In addition, grandparents, family friends, siblings and extended family can all chip in and contribute towards this fund, making it an ideal way to bring the whole gang together to pay for something that will eventually benefit the whole community.

Gifting is one of our favorite ways to save for college, which is why we also like tools like CollegeBacker that make it easy.

Prepaid Tuition Account Opening Requirements

There are certain requirements those who are looking to start these college funds for their students need to meet. To begin with, individuals who are looking to attend college with these funds will need to choose from a selection of state colleges. They may not be able to attend out-of-state colleges, since the money will be subsidized by their own states. Second, parents can only use the money in these accounts for tuition-related costs. If they withdraw a certain amount to pay for other things, they may incur a penalty.

Prepaid Tuition Plan Benefits

Perhaps one of the biggest advantages of a pre-paid tuition plan is the peace of mind that comes with knowing that your child’s future is secure. You no longer have to worry about looking for additional income streams to help you save money into a college savings account. In fact, the financial security that comes with a 529 plan may just give you some leg room to add something extra to your retirement account or even consider investment options to help your money grow.

529 plans are a kind of external motivator to save that really works. Most people aren’t able to do the right thing unless someone else is forcing them to do it. With a prepaid tuition plan, you know that you are obligated to put away a certain lump sum amount or you’ll lose out on having a secure education future for your child.

These plans may also be a lifesaver should you be faced with a divorce later on in life. This is because they could be tied into the settlement which may mean that your spouse won’t be able to shirk the responsibility of making sure that your children are taken care of going forward whether or not he or she is around.

You have a more than 90 percent guarantee when it comes to getting your payout when your children reach college-going age. This is because these plans are up to 93 percent funded by the states that provide them.

They offer some kind of flexibility when it comes to you choosing the type of payment you’d like to make as seen by the three types we covered earlier in this post (see list above).

You’ll be getting more value for your money if you decide to go for a 529 plan. It’s estimated that tuition costs are increasing by up to 8 percent every year. If parents who save in a traditional manner more than 15 years before their child is due to start college, they’ll have to save increasingly high amounts of money on a year-on-year basis to account for inflation as well as this 8 percent yearly increment. You, on the other hand will have locked in your prices well in advance.

These plans are exempt from taxation, making them great tax-free incentives. In addition, you may get a tax deduction if you have a pre-paid plan if your state has this allowance in its tax rules. Plus, withdrawals from the 529 plan are tax free when used for education.

One of the intangible benefits that most people don’t consider when taking out a 529 plan is the fact that their children will be within easy reach. Most of these plans are only valid if students choose to go to state colleges. This means that you as a parent will have easy access to your loved ones, leading to a more cohesive family unit.

Prepaid Tuition Plan Disadvantages

529 plans aren’t available in all states. This basically means that you won’t be eligible for big savings if you live in certain states. At the time of writing this post, there were just 9 states offering this kind of prepaid tuition plan.

These plans may lock your children out of certain opportunities and career paths since they restrict college-goer’s choices; they can only attend colleges in their state, and their plans may only enable them to access certain courses.

There is a certain level of risk that comes with 529 plans due to incidences where states have dropped or limited access payouts in the past. As a result, parents who would like to invest in pre-paid tuition should do extensive research before making any kind of commitment. One can never predict the future; however, with adequate planning, you can avoid or limit your risk.

Applying for a 529 plan may effectively cost your child their share of financial aid. This is because the state will assume that your plan will and should be enough for them to go through college without any financial constraints.

If you sign up for a 529 plan, you’ll have a much smaller pool of financial investments. You are usually required to make your contributions as-is into your 529 account, leaving it there for a specified amount of time. On the other hand, parents who had decided to open a mutual fund may be able to invest their money into different ventures, growing their bottom line over time.

529 plans are at the whim of many factors in the running of a state such as a budgetary shortfall. This means that the security that was initially promised to you and your family may disappear within a year should yours state absorb the ripple effects of a bad economy with regard to budgetary spending. To remedy this potential problem, ask the administrators in your state if there is some kind of guarantee that will safeguard your investment.

Your 529 plan may only cover tuition and administrative fees, leaving you to scrap some money together for essentials such as textbooks and accommodation. This is why it’s so important to do your research and ask all the right questions from the get-go.

There’s a timeframe that a student needs to adhere to when it comes to things like accessing funds as well as usage of tuition credits. For example, most 529 plans require you to withdraw all funds and put them into tuition costs within ten (10) years of the time that your child starts college. In addition, your child should use their credits before they reach the age of 30.

As a parent, you will be required to take an active role in making sure that you keep an eye on your child’s account. You will need to be aware of the changes in state laws regarding education funds as well as national news on the same. Parents with college savings funds can sink money into mutual funds, stocks and bonds and forget about these for long periods of time, letting their money do the work for them.

Clearing the Misconceptions About Prepaid Tuition and Prepaid 529 Plans

Many people think that there’s a cap with regard to how much money they can sink into these types of accounts on a yearly basis. The plan allows individuals to contribute a maximum of $15,000 a year, if they don’t want to file a gift tax return. That being said, you can contribute up to $150,000 into these plans or even combine the $15,000 into a 5-year lump sum of $75,000. These is subject to the gift tax exclusion and state plan rules. Contrary to popular opinion, a 529 plan doesn’t lock you into one type of investment for the duration of its existence. Legislation instituted in 2009 now gives parents and contributors the opportunity to change to a different type of 529 up to two times a year. In addition, you have the freedom to change the beneficiaries of the plan should the original individual decide that college isn’t for them or that they would like to pay their own way going forward. Just because you decide to take out the cash in the plan for other purposes doesn’t mean that you can’t use it for anything else other than college. You can put it to use in the event of an emergency, but be aware that you’ll be charged a 10% penalty as well as forced to pay taxes on that amount. If you decide to withdraw the entire amount, you’ll be able to get your principal amount back without having tax or penalty applied to it. Find your state here and learn about potential recapture penalties. 529 plans aren’t only for college students; they can be used for students attending community colleges where some degrees may take 2 to 3 years, as well as technical schools. That being said, the government and your state will only allow you to use these funds in accredited institutions; this means that foreign and private, unaccredited institutions aren’t covered. Learn more about using a 529 plan for overseas education. Lastly, prepaid tuition is available for individuals of all income brackets. Some families may be of the mistaken opinion that they make too much money to be allowed to open a 529 plan. This couldn’t be further from the truth, and what’s even more exciting is that you can still receive tax breaks if you decide to go for one, regardless of how much you and your wife make jointly.

Conclusion

Prepaid tuition programs can be a great way to save for college. However, they may not be as good a way as other options - like a normal 529 plan.

If you think there is a high likelihood your child will go to an in-state public school, this can be a good way to save on college costs. However, the transfer process if they don't could make it not as attractive as other ways to save for college.

Read our full guide on saving for college here.