Topic:
HIGHER EDUCATION; LEGISLATION; SCHOOL FINANCE; TAXATION (GENERAL); TUITION;
Location:
EDUCATION - HIGHER - FINANCE;

OLR Research Report


November 14, 2008

 

2008-R-0612

PREPAID COLLEGE TUITION PLANS

By: Rute Pinho, Research Analyst

You asked if the legislature has recently introduced any bills to establish a prepaid college tuition program. You wanted to know (1) how such a program would work, (2) its advantages and disadvantages for families and the state, and (3) how other states' prepaid tuition programs have fared.

SUMMARY

A prepaid college tuition plan is a type of tax-advantaged investment plan designed to encourage saving for a child's future college expenses. These plans are known as “529 plans” after the federal tax code provision that offers federal tax advantages to contributions to, and earnings from, such investment plans when the money is used for qualified college expenses, such as tuition, room and board, and textbooks. Many states mirror the federal tax advantages for 529 plans by offering state tax-deferred growth and tax-free withdrawals for qualified education expenses.

529 plans can take two forms: prepaid tuition and savings. Prepaid tuition plans allow parents and relatives to buy all or a part of a child's future college education at an in-state public school. They may also be converted for use at private and out-of-state colleges. Savings plans are different in that the account earnings are based on the market performance of the underlying investments.  Both prepaid tuition and savings plans offer federal and state tax benefits.

Prepaid plans are a more conservative investment option; Families may get a better rate of return by investing in other savings vehicles, particularly for young children. Most prepaid tuition plans have residency requirements and other limitations, including steep cancellation costs, should a child choose not to go to college. Prepaid plans, unlike savings plans, do not cover college expenses such as room and board.

The major incentive for any state in offering a 529 plan, prepaid or savings, is encouraging its residents to save for future college costs. However, in order to cover the future liability of prepaid tuition contracts, a state must invest the pooled funds and get a return equal to the increase of future college tuition prices. Rapidly escalating tuition prices coupled with an underperforming stock market resulted in large actuarial deficits for several states' prepaid tuition plans.

The legislature considered a bill in 1995 to establish a prepaid tuition program. The Education Committee held a public hearing on March 14, 1995 but did not take any further action on the bill. In 1997, the legislature established a state-sponsored college savings plan rather than a prepaid tuition plan.

529 PLANS: PREPAID TUITION VERSUS SAVINGS PLANS

A prepaid college tuition plan is a type of tax-advantaged investment plan designed to encourage saving for a child's future college expenses. These plans are known as “529 plans” after the federal tax code provision that offers federal tax advantages to contributions to, and earnings from, such investment plans when the money is used for qualified college expenses, such as tuition, room and board, and textbooks. Many states mirror the federal tax advantages for 529 plans by offering state tax-deferred growth and tax-free withdrawals for qualified education expenses.

The plans, which are administered by state agencies and organizations, can take two forms: prepaid tuition and savings. Table 1 compares the two types. Prepaid tuition plans are also referred to as guaranteed savings plans. They allow parents and relatives to buy all or a part of a child's future college education at an in-state public school. Most plans require either the plan owner or beneficiary to be a state resident. They may also be converted for use at private and out-of-state colleges. A prepaid plan may be either a contract or unit plan. A contract plan allows someone to purchase a contract covering one to five

years of tuition, either on a lump sum or installment basis. A unit plan allows the purchase of tuition units which may equate to credits or hours.

Savings plans differ in that account earnings are based on the market performance of the underlying investments. Participants, who may or may not be residents of the state that offers the plan, may contribute to an investment or savings account on behalf of a child. Amounts contributed and any earnings on the account may be used to pay the child's qualified expenses at any college. The plans offer various investment options that provide a variable rate or return usually based on stock or bond funds.

Table 1: Comparison of 529 Plans

Prepaid Tuition Plan

College Savings Plan

Most plans allow you to prepay tuition at eligible public and private colleges and universities at today's price.

No lock on college costs.

All plans cover tuition and mandatory fees. A few plans allow a room and board purchase option, use excess tuition credits for other qualified expenses, or cover all qualified education expenses.

Covers all “qualified higher education expenses,” including:

Tuition

Room and board

Mandatory fees

Books, computers (if required)

Most plans set lump sum and installment payments prior to purchase based on age of beneficiary and college tuition years purchased.

Many plans allows contributions over $200,000.

Many state plans guaranteed or backed by state.

No state guarantee. Most investment options are subject to market risk. Investments may make no profit or even decline in value.

Some state plans have age/grade limits for beneficiaries.

No age limit. Open to adults and children.

Most state plans require either plan owner or beneficiary to be a state resident at the enrollment time.

Most plans do not have a residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers.

Most plans have limited enrollment period.

Enrollment open all year.

Source: Smart Saving For College, Financial Industry Regulatory Authority (FINRA)

Table 2 shows states that currently offer a prepaid tuition plan or have done so in the past. There are 14 prepaid tuition plans accepting new enrollments; 13 are state-sponsored plans and one is sponsored by a nonprofit membership organization comprised of participating colleges and universities. (In the Independent 529 Plan, each participating institution makes a binding commitment to accept tuition certificates in payment of tuition and fees.) Colorado, Ohio, Pennsylvania, Texas, and Washington are no longer accepting new enrollments in their plans. Texas, which suspended enrollment in its contract plan in 2003, recently launched a new unit-based prepaid plan.

Table 2: States Offering Prepaid College Tuition Plans

States

Contract Plan

Unit Plan

Accepting New Enrollments

Alabama

 

Yes

Colorado

 

No (as of August 1, 2002)

Florida

 

Yes

Illinois

 

Yes

Kentucky

 

No (as of December 2004)

Maryland

 

Yes

Massachusetts

 

Yes

Michigan

 

Yes

Mississippi

 

Yes

Nevada

 

Yes

Ohio

 

No

Pennsylvania

 

Yes

South Carolina

 

No (as of July 1, 2008)

Tennessee

 

 

Yes

Texas

Yes- unit plan;

No- contract plan (as of 2003)

Virginia

 

Yes

Washington

 

Yes

West Virginia

 

No (as of 2003)

Independent*

 

Yes

*Not a state-sponsored program. The sponsor is Tuition Plan Consortium LLC, a nonprofit membership organization composed of participating colleges and universities.

Source: www.savingforcollege.com

 

Each state's plan works a bit differently. In general, the plans allow parents and relatives to buy tuition for a child at a fixed price. The cost depends on the number of years until the child first enters college. Families may purchase the tuition (in years or units) in full or pay in installments and are guaranteed that their investment will keep pace with rising college costs. Families come out ahead if the tuition costs rise faster than the average and would do worse if college costs did not rise as fast. Historically, tuition costs have outpaced the inflation rate.

ADVANTAGES AND DISADVANTAGES

Families

Tax Benefits. Both prepaid tuition and savings plans offer federal and state tax benefits. These can include tax-deductible contributions and tax exemptions or deferrals for money paid out to student beneficiaries.

Covered Educational Expenses. Prepaid tuition plans do not cover college expenses such as room and board; Savings plans do.

Return on Investment. Prepaid tuition plans are a more conservative investment option for families. Unlike savings plans, prepaid plans have no investment options. Accounts are guaranteed to at least match in-state college tuition increases. On the other hand, parents may get a better rate of return by investing in 529 savings plans or other savings that seek higher returns, particularly for young children.

Residency Requirements and Other Limitations. Unlike college savings plan, most state prepaid tuition plans require either the parent or child to be a state resident when applying for the plan. Some limit enrollment to a certain period each year. Many plans also have age or grade limits for the beneficiary.

Cancellation Costs. Prepaid plans are designed to be used at in-state public colleges and universities. If a student decides to attend a private or out-of-state college, most plans will pay out an amount equal to the weighted average tuition and mandatory fees at the state's public institutions, not to exceed the actual tuition and fees incurred. Most plans allow a family to transfer the amount to a sibling, but age restrictions may prevent transfers to an older sibling. If a child chooses not to go to college and a sibling doesn't use the plan, most plans will refund the original cost of the plan with a reduction or elimination of any interest earned. Some plans may also charge a cancellation fee.

Impact on Financial Aid Eligibility. Any investments or savings can affect federal financial aid eligibility. The impact varies depending on whether the savings belong to the parent or the child. Under a 2006 federal law, prepaid plans and savings plans are both treated as parents' assets for financial aid purposes. Savings in a parent's name can reduce federal financial aid eligibility by at most 5.64%. With many other savings vehicles or assets saved in a child's name, 20% of the asset is considered in determining the amount the family is expected to pay toward a child's higher education.

Some states exclude the value of a prepaid tuition contract for state financial aid purposes. Given that most need-based financial aid is in the form of student loans, any savings accumulated for college expenses may help reduce the parent's or student's future debt load.

College Admission. A prepaid tuition plan does not guarantee college admission. A child must still meet entry requirements as determined by individual colleges or universities.

State

 

The major incentive for any state in offering a 529 plan, prepaid or savings, is encouraging its residents to save for future college costs. However, in order to cover the future liability of prepaid tuition contracts, a state must invest the pooled funds and get a return equal to the increase of future college tuition prices. Rapidly escalating tuition prices coupled with an underperforming stock market resulted in large actuarial deficits for several states' prepaid tuition plans. Several states, such as Texas, Ohio, and Kentucky, ran into deficits and froze enrollments because the cost of tuition was outpacing the money invested. Other states, such as Florida, have had to increase prepaid contract rates by as much as 15% to keep pace with tuition increases.

Most states back their prepaid tuition plans by the full faith and credit of the state, meaning that if the program should find itself in financial difficulty, the state must step in to provide the necessary funding. Other states do not have a formal guarantee, but do have a formal process by which the state's legislature will consider making an appropriation if necessary. Some states offer no guarantees that the plan will fund the future cost of tuition or that the state will step in should the plan falter.

Kentucky. In December 2004, Kentucky's Affordable Prepaid Tuition Fund board approved a $13.7 million transfer from the state Unclaimed Property Fund to eliminate the program's actuarial deficit. In 2006, a Kentucky judge ruled that the General Assembly acted unconstitutionally when it tried to return the $13.7 million to the state's reserve fund (Chronicle of Higher Education, April 28, 2006). In his ruling, the judge affirmed that the state must honor the prepaid contracts. Kentucky stopped accepting new enrollments in its prepaid program in December 2004.

Texas. Texas suspended enrollment in its first prepaid plan in 2003 when rapid tuition increases caused by the deregulation of Texas public schools put the program fund under severe financial stress. The state's new program shifts the tuition risk associated with the prepaid contracts to the state's public universities and colleges, reducing the need for a program reserve and allowing the program to peg unit prices at current tuition levels.

Colorado. Colorado's Prepaid Tuition Fund suspended enrollment in August 2002 because of a concern that the state wouldn't be able to protect its assets and remain solvent. The Colorado Bond Authority was forced to tap into a reserve of $7.7 million to keep the program in operation after the Colorado legislature declined to bail it out (State Legislatures, May 2004).

PREPAID TUITION PLAN PROPOSALS

The legislature considered a bill in 1995 (Raised HB 6900) to establish a prepaid tuition program.  The Education Committee held a public hearing on March 14, 1995 but did not take any further action on the bill. In 1997, the legislature established the Connecticut Higher Education Trust (PA 97-224), a state-sponsored college savings plan.

During the March 3, 1997 public hearing for the college savings program bill (HB 6771), state treasurer Chris Burnham remarked:

The prepaid college tuition program, something which we suggested, although not wholeheartedly recommended the way we did the college savings account, is something which I think individual colleges should be permitted to offer at their own risk. We are responsible for state schools. We may not want to do it for our state college system because of the implied unfunded or potential unfunded liability with the prepaid college tuition program.

RP:dw/ts