j.o.h.n. walker via Flickr A lot of people could not resist the lure of tax-favored 529 plans that promised to lock in relatively low tuition for youngsters a decade or more before they reached college.

But the inexorable law of finance is that there is no risk-free lunch, and it is turning out that some promises were too good to be true.

Prepaid 529 plans across the country have promised more in tuition benefits than they have the funds to deliver. In some cases, taxpayers are obliged to take up the slack, while in others the colleges themselves may be required to offer discounts to make good on the promised benefits.

In still other cases, however, parents and grandparents who thought they bought the right for their offspring to attend college at a prepaid rate are likely to find themselves stuck with a broken pledge and a tuition bill, with no better recourse than to ask state legislators to bail them out.

State legislators, we should note, are not exactly flush with disposable cash these days.

Tax-favored 529 plans come in two flavors. College savings 529 plans (the “529” refers to a section of the Internal Revenue Code) operate in a manner similar to a Roth IRA. Account owners make non-deductible contributions to an investment account for a dedicated purpose – in this case, higher education.

In exchange for agreeing to use the money for that purpose only, they do not owe taxes on the plan’s investment earnings when they withdraw the money. There is a tax for making non-qualifying withdrawals, but otherwise, account owners can manage the money as they please, choosing the degree of risk they are willing to accept.

Prepaid plans, on the other hand, theoretically shift risk onto a plan sponsor, much as a defined benefit retirement plan does. In these plans, account holders purchase college credits at a cost that is equal to or slightly higher than the present tuition rate. The 529 plan sponsor then invests the money with the goal of generating enough in investment returns to offset increases in tuition.

All but one of the prepaid plans are offered by states, and the tuition-matching offers apply only to in-state public schools. The one exception, the Private College 529 Plan, is sponsored by 270 private colleges and allows credits to be used for tuition at any of those schools. The cash-to-credit ratio for each school in the private plan depends on its tuition rates at the time the money is invested.

On the surface, prepaid plans offer greater peace of mind than savings plans, because they come with a “guarantee” that investments will keep up with rising costs. However, only a handful of states, including Florida, Massachusetts, Mississippi and Washington, have actually put the full faith and credit of their state treasuries behind their prepaid 529 offerings, pledging to make up the difference if the plans fall short of their obligations. Texas and the Private 529 Plan have created a guarantee in a different way, by making participating schools promise to accept the prepaid credits regardless of future tuition increases.

For account owners in the other prepaid plans, success depends mainly on the performance of the plans’ portfolios compared to the rate of tuition increases; any government backstop depends upon the future goodwill of legislators.

So far, most of the plans haven’t done very well on the investment performance front. As of June 30, 2010, Illinois’ plan had $1.35 billion in assets and $1.69 billion in liabilities, according to The New York Times. Like pension plans, prepaid 529s tend to overestimate future investment performance while they underestimate their obligations.

The Illinois plan is a dramatic example. In 2006, it allowed parents of newborns to buy an eight-semester contract for tuition at the state’s flagship university for $41,493. Since then, the tuition cost for eight semesters has soared to $95,521.

If non-guaranteed plans run out of funds, they must go to state legislators to beg for assistance. Last year, Alabama’s plan did just that. Account holders there were fortunate; the plan received the money it needed. But as the states’ giant pension obligations become more obvious, it is likely that they will be less generous in bailing out programs they are not legally obligated to back.

Jim Durkin, a lawyer and Republican state representative in Illinois who also has money in that state’s prepaid 529 plan, told The New York Times that if the plan came to the state for money, “I guess the response would be, ‘Get in line.’”

Apart from their financial viability, prepaid 529s carry another risk that could strike closer to home. What if, after years of participating in a prepaid 529 plan, you discover that your child does not want to attend a school that accepts the credits? New York, where I raised my two children, does not have a prepaid 529 plan, so if I had wanted a prepaid option, I probably would have had to go with the private plan.

Out of curiosity, I decided to look at the 270-school list to see if it included my daughters’ choices. My eldest daughter’s alma mater, Emory University, was the list, as were many of the other schools she visited. Northwestern University, where my younger daughter is now pursuing a degree in journalism, was not.

All of the plans offer a way to withdraw contributions if students choose not to use them – assuming the plan hasn’t gone broke. In many cases, however, the original contributions are all that investors can get back. The private plan is more generous than some, offering to return investment gains “based on the net performance of the Program Trust,” but increases and losses are capped at 2 percent a year. Any gains achieved beyond that are lost.

As the S&P’s recent downgrade of U.S. Treasury debt confirmed, there is no such thing as a risk-free investment. States that tried to pretend there was no risk involved in managing their residents’ college funds are realizing that now. Today’s generation of students is likely to be the last, as well as the first, to grow up with prepaid 529s. Since 2000, Alabama, Colorado, Kentucky, Ohio, South Carolina, Tennessee and West Virginia have all stopped accepting new enrollments in their prepaid programs.

I have never used or recommended a prepaid 529 plan. Betting on a promise that a state isn’t willing to fully back and predictions about what an 8-year-old will want at age 18 is not a risk I’m willing to take.

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