At some private colleges, students can potentially save thousands on tuition costs by prepaying for upcoming academic terms. But, despite the cost savings, there are some potential drawbacks to using a college’s tuition prepayment plan.
What is a college tuition prepayment plan?
Tuition prepayment plans help families hedge against inflation by offering a fixed tuition cost for the next 2, 3 or 4 years of college. Some colleges offer a discounted tuition rate for students who prepay.
Tuition prepayment plans are not the same as state sponsored prepaid tuition plans, or the Private College 529 Plan. Families typically open a prepaid tuition plan when their child is young, and they have a longer investment time horizon. Tuition prepayment plans offered by colleges are designed for currently enrolled students.
For example, Dartmouth College allows students to pay for tuition for future academic terms at the current rate. The prepayment option only applies to tuition costs. Fees, room and board and other expenses must be paid as they are incurred.
Tuition costs for the undergraduate program at Dartmouth College for the 2018-19 academic year are $55,605. According to the College Board, tuition costs at private nonprofit 4-year colleges are rising at 3.3%. However, according to College Navigator, Dartmouth's recent tuition inflation rate has been above average, at 3.9%.
If Dartmouth tuition rises at 3.9% over the next 4 years, total 4-year tuition costs for a student enrolling this year would be over $235,000. By taking advantage of Dartmouth’s tuition prepayment plan, students could potentially save over $13,000 in college costs.
Traditional Payment (3.9% inflation rate)
Total tuition costs
Source: College Board, Dartmouth College and CollegeNavigator.gov
Drawbacks of prepaying tuition
Paying for 4 years of college upfront is very expensive and may not be realistic for all families. Before prepaying college tuition, families should make sure they have sufficient funds to cover other expenses, including an emergency fund.
There is also the chance that the student is unhappy at the college and wants to transfer after their freshman or sophomore year. Most colleges have the same refund policy for prepaid tuition as traditional tuition if the student withdraws, but the student will have to pay the current tuition rates at their new college.
Parents who use cash to prepay tuition may not be eligible to claim the American Opportunity Tax Credit (AOTC) in upcoming tax years. Qualified expenses for the AOTC must be paid in the current tax year and may include expenses incurred during the tax year or the first three months of the following tax year.
When a child’s college savings are invested in a 529 plan or other investment account there may be an opportunity to earn more than the 3.3% average tuition inflation rate by keeping the funds in the account until tuition is due. Investment earnings in a 529 plan compound tax-deferred and can be withdrawn tax-free to pay for college. Most states also offer a state income tax deduction or state tax credit for 529 plan contributions. Parents can get the equivalent of a discount on college tuition by funneling payments through a 529 plan, claiming a state tax break and immediately withdrawing the funds to pay tuition.
Using 529 plan distributions to prepay tuition
Qualified 529 plan expenses must be incurred in the same tax year as the qualified distribution. But, generally, the distribution is also considered qualified when it is used to prepay college tuition for subsequent years.
Colleges will send a Form 1098-T noting the amount of 529 plan payments received, and the amount billed for tuition. If the student is prepaying tuition, the amount billed should reflect the total amount of tuition they are paying upfront.
Keep in mind that Form 1098-T only includes college tuition. The form does not include other qualified 529 plan expenses, such as room and boar costs, computers and internet access or K-12 tuition.