The new education IRA has gotten all the press. But state by state, a better savings opportunity is quietly emerging for parents or grandparents saving for a youngster's future college expenses.
As recently as two years ago, fewer than a dozen states offered programs to help families save for college, and most of those were prepaid-tuition plans with numerous restrictions. Now, 20 states have some type of state-sponsored tuition savings plan, 20 others have committed to starting one and nine more are studying the idea.Most of the newer programs are an improvement over the old prepaid-tuition plans. Among other advantages, savings plans have a gentler impact on financial-aid eligibility, and many are exempt from state tax.
Most also have the potential for higher returns, but without the guarantee that your payments today will cover tuition tomorrow. Prepaid-tuition plans let you buy up to four years' worth of tuition at current prices, either in installments or as a lump sum. The appeal is the guarantee that when your child is ready for freshman year, your account will cover tuition, no matter how much the price has risen.
Your return in such plans is roughly equivalent to the rate of tuition inflation at public colleges and universities in your state - which made the plans extremely attractive when tuitions were rising at 10 percent or more a year. Today, with the average rate of tuition inflation closer to 5 percent, prepaid plans are no match for investing in the stock market when you have more than a few years before you'll need the money.
Many of the newer savings plans are basically state-run investment accounts that invest for stock- or bond-market returns. You decide how much to contribute, and the state pays you a return based on the investments it chooses for the entire pool of participants. Under federal law, you cannot choose your own investments, as you can in an education IRA or Roth IRA.
The Kentucky Educational Savings Plan Trust takes the safe road, investing primarily in Treasury securities. Since 1991 it has paid returns that range from 5.6 percent to 9.2 percent. The Indiana Family College Savings Plan, on the other hand, directs contributions into a portfolio of stocks and bonds that has returned an annualized 16.9 percent over the past three years.
Most plans have the potential for higher returns, but without the guarantee that your payments today will cover tuition tomorrow. Prepaid-tuition plans let you buy up to four years' worth of tuition at current prices, either in installments or as a lump sum. The appeal is the guarantee that when your child is ready for freshman year, your account will cover tuition, no matter how much the price has risen.
Prepaid plans are a bad idea for families that expect to be eligible for substantial need-based financial aid because prepaid tuition is considered a resource that reduces your financial need dollar for dollar.
College-savings plans reduce your financial need, too, but to a lesser degree. Depending on how the account is titled in your state, they're included among either the parents' assets (meaning financial aid is reduced by 5.6 percent of the balance in the account) or the student's assets (with need reduced by 35 percent of the balance).
Despite those downsides, though, many parents have enthusiastically signed up for the prepaid plans because they deliver what savings plans and the stock market don't - a sure thing. Whether college costs rise by 2 percent or 10 percent annually, prepaid-plan participants know that their contributions will cover all or a predetermined portion of the tuition bill at a public college (and even a private one in a few states).
If that reassurance is a sufficient return for you, then a prepaid plan may be your preference. But you may need to save separately for room and board or for the cost of a private college over a public one.
Savings plans, on the other hand, seldom guarantee returns and can even lose money, depending on how the plan invests. The prospectus or annual report should specify what kinds of investments the plan may make and whether you can expect a minimum return.