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The '529 Guru' offers his random thoughts.

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01/11/2012: An article from Reuters this morning does a nice job discussing the financial woes that have closed or suspended enrollment at some of the state-run prepaid tuition plans over the past few years. The article also describes the concerns of current plan participants in those states where the plan assets are projected to run short, and where the promise to pay future tuition is not backed by the full faith and credit of the state.

Yet, a few states continue to offer an attractive prepaid tuition plan to their residents. In fact, if you live in one of the states mentioned below, or intend that your child attend college in one of those states, you should consider yourself fortunate; you may have a compelling college-savings option available to you that many others do not. (Naturally, you will want to thoroughly study your options before making any investment decisions.)

Here are the plans that currently offer the best prepaid tuition deals, based on the analysis that supports Savingforcollege.com’s 5-Cap Ratings:

University of Alaska College Savings Plan (Rating: 5 caps for residents and 4.5 caps for nonresidents)

You won’t see this 529 plan characterized on Savingforcollege.com as a prepaid tuition plan because we include it with all the 529 savings plans. In fact, it mirrors the T. Rowe Price College Savings Plan with one important distinction: the University of Alaska plan has an investment option called the ACT option that the T. Rowe Price College Savings Plan does not have, and anyone who selects the ACT option is allowed to redeem it for equivalent tuition at the University of Alaska (if your child ends up going to that school for an undergraduate degree). Equivalent tuition is the amount of your contributions to the ACT option, inflated by future years’ tuition increases at University of Alaska.

Even better, if the investments in the ACT option (a low-cost blend of T. Rowe Price index funds) happen to grow faster than the rate of tuition increase at the University of Alaska, you receive the investment value of the account, regardless of where your child attends college.

The University of Alaska 529 Plan is not restricted to Alaska residents, Nonresidents who are thinking about sending their children to the University of Alaska are also eligible for the ACT guarantee, and they may even gain the advantage of paying in-state tuition rates under certain circumstances.

If your child does not attend the University of Alaska, the ACT option can be redeemed at its investment value for any eligible institution, just like any other 529 savings plan.

The ACT guarantee is not backed by the full faith and credit of the state of Alaska, but the University of Alaska is an agency of the state, so the lack of state backing should not be of as much concern. The plan also provides a creditor asset-protection feature.

Massachusetts U.Plan (Rating: 4 caps for residents, 3.5 caps for nonresidents)

This is the only state-run prepaid tuition plan that is not, technically speaking, a 529 plan, so all the special income- and gift-tax rules under section 529 of the tax code do not apply to the participants in this plan. Yet you still escape income tax because with this plan you are purchasing general obligation bonds issued by the Commonwealth of Massachusetts, and these bonds qualify for federal and Massachusetts exemption because they are municipal bonds. (Nonresidents may end up paying tax to their own state.) You also receive the Commonwealth’s full faith and credit backing.

The Commonwealth has entered into an agreement with some 80 colleges and universities—both private and public but all located within Massachusetts—that obligate those schools to accept the bond redemption proceeds in payment of tuition. And the amount of tuition is tied directly to the tuition increases at the school during the bond’s holding period, much like Alaska’s ACT option described above. Bottom line: you are buying future tuition at today’s rates.

If you purchase U.Plan and your child does not attend one of the participating institutions, you may redeem the bonds upon their maturity to include interest computed based on the increases in the Consumer Price Index (CPI).

I have often wondered why no schools outside of Massachusetts have ever signed on to become part of U.Plan; there appears to be nothing to prevent non-Massachusetts schools from participating. Of course, we now have the Private College 529 Plan, described below, that was modeled after U.Plan, but targets private colleges, not public institutions, for participation.

Mississippi MPACT (Rating: 4.5 caps, residents only)

Talk about a sweet deal for Mississippi residents! With this “traditional” prepaid tuition plan you get contracts priced close to current tuition levels; a full deduction on Mississippi income tax returns for payments made into the plan; favorable cancellation provisions; full-value portability for use at private colleges and schools outside Mississippi; and exclusion from state-level financial aid formulas.

And, importantly, it shouldn’t matter that this plan was the country’s most underfunded prepaid tuition plan that was still open to new enrollment (according to an October 2011 report prepared by the state of Washington’s GET program), because its obligations to participants are backed by the full faith and credit of the state of Mississippi.

The biggest problem with this plan is that the most recent enrollment period ended on December 31, 2011 and if you are a Mississippi resident and not already in the plan, you may have missed out. States with funding problems tend to take actions to resolve those problems, and that may lead to a different deal in the future.

Private College 529 Plan (Rating: 4 caps)

This is the only 529 plan that is not a state-sponsored plan. Interestingly enough, it was patterned after the Massachusetts U.Plan which, as mentioned above, is the only state-sponsored plan that is not a 529 plan. Regardless, the tuition deal is similar, although the players are different.

PC529 has enlisted approximately 270 private colleges from around the country to accept the plan’s “tuition certificates” in payment of tuition at their schools. When you buy a tuition certificate you are buying a specified percentage of tuition at each of the participating schools, so that when your child attends one of those schools, the pre-determined percentage is used to compute the amount of tuition that gets paid by the plan.

So yes, you are buying future tuition at today’s prices with this plan.

If your child does not attend a participating school, or you simply want to cancel, your tuition certificate can be redeemed for an amount tied to the investment performance of the plan’s underlying fund assets. Because of IRS restrictions, the performance adjustment is “collared” so net positive performance provides an average annual return of no more than 2 percent, and negative fund performance costs you no more than an average of 2 percent annually. The program is managed by OppenheimerFunds.

Not being a state plan, the question of state backing becomes moot. However, the investment risk in this type of plan is ultimately placed on the participating schools, and not carried by the plan itself or its enrollees.

Texas Tuition Promise Fund (Rating: 4 caps, resident only)

To me, the Texas plan is the model that other states should look to when looking to develop a prepaid tuition plan. I sometimes refer to this plan as Texas II because the state’s original prepaid plan, the Texas Guaranteed Tuition Plan (“Texas I”), was a traditional prepaid plan that failed under the weight of huge public tuition increases resulting from the deregulation of Texas public institutions. Fortunately, enrollees in Texas I are protected by the state’s full faith and credit backing of the severely under-funded plan and Texas state legislators are left with the task of coming up with the funds to bail it out.

Texas II works much like the Massachusetts U.Plan and the Private College 529 Plan by shifting the investment risk to the schools. The difference is that Texas adopted a law forcing the state public school to accept the deal, unlike the voluntary school participation that U.Plan and PC529 rely on.

Of course, the Texas legislature could not force private colleges and public institutions outside of Texas to accept the deal, and so if you enroll your child in this plan (open only to Texas residents) and he or she does not attend a Texas public college or university, then the value of your account is tied directly to the program fund’s investment performance, good or bad.

By shifting the investment risk to the schools, the plan is able to price its contracts at current tuition levels, which most other state-run prepaid plans are not able to do.

Will other states actually adopt the Texas II model? Probably not too many, since few other state legislatures would have the political will and power to force their public university systems to accept the risk that investment returns do not keep up with tuition increases at their institutions.

Virginia Prepaid Education Program (Rating: 4 caps, resident only)

Virginia’s prepaid plan is not backed the Commonwealth’s full faith and credit. However, it does have a “legislative guarantee” that provides fairly solid assurance that funds will be appropriated if necessary to deliver the plan’s tuition promises. It also helps that millions of dollars in fees collected each year from the country’s largest 529 savings plan, the CollegeAmerica plan that is distributed through American Funds, are available to buttress the prepaid fund’s coffers.

Virginia’s plan also charges its new contract holders a hefty premium over current tuition levels. Rather than buying future tuition at today’s prices, you are buying future tuition at a price well above today’s tuition. Yet, if the projections of future Virginia public tuition increases hold true, the premium may still be worth paying. In any case, you are able to roll over your contributed dollars, plus interest, to Virginia’s 529 savings program (VEST) if the prepaid plan no longer looks like where you want to stay.

Beyond those considerations, the prepaid plan offers Virginia residents a nice set of extra benefits. Payments into the plan can be deducted from Virginia taxable income at the rate of $4,000 per year, with unlimited carryover of excess amounts. Accounts are excluded from consideration in Virginia’s need-based financial aid programs. And there is also a law protecting accounts from the claims of creditors.

There are not too many “traditional” prepaid plans still able to chug along to the satisfaction of state and participant alike, but this is one that seems to be working well.

Past Blogs

12/22/2011: I posted a note on Twitter yesterday (@529Guru) wondering why some writers feel a need to lambaste 529 plans for having a limited number of investment options. Sure, I understand that some people like to select individual stocks, or bet on which direction the market is going, but is that really a good way for you to handle your college savings? If you say “yes,” then you are prob... Read More

11/30/2011: We went out on a bit of a limb today with a Savingforcollege.com press release that declares conditions for families using 529 plans to be "near perfect." I truly believe this to be the case, and the press release outlines six reasons for this belief. Today's press release flie... Read More

11/15/2011: It's not often we see the IRS going to court over a Section 529 tax dispute, so when it does happen we take notice, even when the case cannot being used as precedent for future cases. In Karlen v. Commissioner (T.C. Summary Opinion 2011-129), the U.S. Tax Court decided a case involving distributions paid by the N... Read More

10/27/2011: From all reports our annual 529 industry conference last week in Las Vegas was a success and I am grateful to all the speakers and attendees (over 160!) that came to the conference. With all that industry knowledge fresh in my mind, here are four trends that have taken hold among the states and their 529 program managers. Lower fees and expensesRead More

10/11/2011: A remedy for the investment-change blues? The investment change restriction that 529 plans are subject to—you are allowed switch investment options in your 529 plans once during any calendar year--is unfortunate and unnecessary. It’s there only because Congress back in 1996 decided you could enjoy all the generous benefits of 529 plans only if you agree to leave the investments up to the... Read More

10/03/2011: Why can't a 529 plan be more like a health savings account? Anyone with a high deductible health insurance plan (HDHP) likely knows about health savings accounts: HSAs are savings vehicles that can be set up by individuals and used to pay medical expenses. The interest or other investment income earned in the HSA is tax-free when withdrawn for IRS-prescribed purposes. Sounds somethin... Read More

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