Although how to pay for children's college remains a pressing concern for American families, many are unfamiliar with the pre-paid savings plans offered by federal and state governments to help with the task. Also known as 529 plans, they provide similar tax benefits to Roth Independent Retirement Accounts and offer two options to allow parents to tailor their funds to their own needs.
The more commonly known is a traditional 529 account which grows based on investment returns and allows withdrawals once the child in whose name the account has been created reaches college age. However, many states – as well as the federal government – also provide a pre-paid option for those hoping their kids attend private colleges. This type of 529 plan allows families to lock in today's tuition rates at over 270 private colleges and universities around the country.
"Families contribute to a trust and get a certificate representing a share of tuition at current rates, a proportion that remains constant even as tuition rises," says Nancy Farmer, president and CEO of The Private College 529 Plan, a private college savings plan.
"So, for instance, if you were to pay in $10,000, and the tuition at a given college were $40,000, the certificate you bought would be worth a quarter of one year's tuition at that college," she says. "If, in 10 years, the tuition is $60,000, your certificate would be worth a fourth of that amount, or $15,000. Money must be in the plan for a three-year vesting period before it can be used."
If the present rates of tuition growth continue over the next decade, taking advantage of a pre-paid plan could translate to substantial savings down the road. US News & World Report explains that parents who managed to put away $27,230 into their pre-paid 529 plan would receive a certificate "redeemable" for a year of tuition at New Jersey's Princeton University which could cost more than $40,000 a decade from now. This represents a 50% rise in value over ten years.
Certificates can end up worth more if purchased in June than July. For example, if parents buy tuition certificates this month, they're buying tuition at the 2012-2013 cost to be used whenever the student attends school in the future at that year's rates, Farmer says.
Since tuition will likely rise in July for 2013-2014, there will be a smaller difference between the cost of tuition in the 2013-2014 school year and when the student uses the funds. Credits work at any of the colleges that participate in the plan, so it doesn't matter which of those schools a student picks, she says.
Farmer notes that the pre-paid 529 plan does offer some protection to parents whose kids end up enrolling in a public school instead. The money can be withdrawn from the plan with no more than a 2%-4% loss in value.