By: John Pitlosh, CFP, MST
If you are like the many thousands of people trying to save for a loved one’s college education, the idea of investing in a 529 plan used to seem like a no brainer: invest a large chunk of money in the stock market and take advantage of the tax-free growth. Now that equity funds have gotten crushed and fixed-income options have incredibly low yields, the question begging to be answered is, “Where can I reliably invest my 529 funds?” The answer to the question is simple: tuition.
While tuition isn’t an asset class that you can buy in a regular 529 savings plan, you can avoid the effects of compounding tuition inflation by investing in a 529 pre-paid tuition plan. There are several pre-paid tuition plans out there, but the “Independent 529” is the one you need to look at if any of your children are likely to attend a private college like Princeton.
Background on the Plan
The purpose behind the Independent 529 is to give parents the ability to lock in current undergraduate tuition rates with a discount at participating private colleges and universities. The Independent 529 plan is the only prepaid 529 program that is a not a state-sponsored initiative and has a nationwide menu of schools with a growing list of more than 270 private colleges and universities.
The prepayment of private college tuition is an important distinction from state versions of pre-paid programs, because state schools will limit their prepayment benefit to in-state public universities and community colleges. So if you wanted to go to a private school in your home state, the value gained by using a prepaid program will probably get torpedoed. Another distinction of the program is the quality of its participating schools, which includes an extensive list of elite schools like MIT, Duke, Stanford and the University of Chicago.
The plan is operated by a nonprofit organization that was created and is run by the participating member colleges and universities. The plan operations and investment management are run by affiliates of TIAA-CREF, which is one of the country’s largest pension fund managers and also runs several state 529 Savings Plans.
Certificate Purchase –Tuition certificates are the currency of the Independent 529 program and they work in a very straight-forward manner. When you spend $10,000 on a certificate on a specific day, that $10,000 certificate will lock in a percentage of tuition at every school on the member list based on their cost schedule and discount rate. When the certificates are booked in this simplistic manner, it makes it easy for the purchaser to track.
For example, a $10,000 certificate bought on February 2, 2009, will buy you 30% of a full year of tuition at School A, whereas that same $10,000 purchase at School B will only buy you 20% of a full year of tuition.
Tuition Inflation – Locking in current prices and avoiding tuition inflation is always going to be the primary benefit of a prepaid tuition program. This point is reinforced by data published by the College Board for the 2008-2009 school year. In a year where the markets were crushed, tuition and fees at a four-year private college went up an average of 5.9%. If you look at 20- and- 30-year timeframes, the annual rate of tuition inflation has averaged somewhere between 6-9%. The value afforded to parents allowing them to transfer the risk of tuition inflation to another party can be an excellent and reliable “investment” as long as the party assuming the risk can handle it.
Risk Assumption – Fortunately for purchasers of the plan’s tuition certificates, AIG isn’t in charge of risk assumption for the Independent 529; instead, the risk for honoring the tuition certificates is ultimately assumed by the member schools themselves. As a precondition of membership into the Independent 529 program, each new member school has to accept the obligation to redeem all tuition certificates that were issued prior to a new school’s membership into the program along with any certificates issued during their time as a member. As a result, even a school that drops out of the program in later years is still on the hook for honoring all the certificates that were issued up until the day they officially left the program.
Because the risk is being spread across the investment trust and all the schools, it would seem that the system is better equipped to handle the risk than your typical state funded plan that periodically shuts down the program to new entrants or digs into taxpayer dollars.
Tuition Discounts – The Independent 529 adds an additional layer of frosting onto its cake, because all the member schools offer an annual discount to their tuition of at least 0.50% for every year that you don’t redeem the certificate, and some schools offer discounts as high as 4%. If you go to A-11 in the disclosure booklet of the plan you can see how the discount formula is applied.
For example, school A has 2009 annual tuition of $25,000 and offers an annual discount of 1%.
Year one day one tuition = $25,000 and end of year one discount (1%) = $250
Year two day one tuition = $24,750 and end of year two discount (1%) = $247
Year three day one tuition = $24,503 and end of year three discount (1%) = $245
The further out you redeem the certificate, the larger the total discount becomes. In the above example, the total discount at the end of year three is $742. Keep in mind that each tuition certificate expires after 30 years, so there is a limit to the benefit. However, the discount really is gravy on top of the tuition lock-in.
Working Within Plan Limitations
The benefits in a prepaid tuition plan like the Independent 529 can be a steal if your child goes to a member school, but like all prepaid tuition plans, it has more limitations than its 529 Savings Plan brethren. If you are aware of the boundaries and can work within the plans limitations it can help make your overall college planning more effective.
No Admission Guarantee – There is no guarantee that your beneficiary will get into any of the plan’s member schools, so this plan will be more realistic for families with a history of attending private schools or ones that is committed to sending their children to one of the schools on the list. It will work even better in that situation if you have multiple children that you are saving for as you can transfer the benefit to a sibling if one of them doesn’t get in or use the full benefit.
Limit on Qualified Expenses – The certificates can only be redeemed to cover undergraduate tuition and a very finite list of mandatory expenses. On the other hand, a 529 Savings Plan that invests in mutual funds can be used to cover a much broader array of expenses that are part of the cost of attendance like room and board. By definition, a prepaid tuition program won’t cover every expense, so it should be balanced out with a 529 savings plan to add more flexibility.
Non-Tuition Redemption – The benefits can be fantastic if you use them for tuition, but they are like bad savings accounts that can lose money if they are redeemed for some other purpose. The best investment result is 2% per year and the worst result is -2% per year. In many cases, that is still better than state sponsored prepaid tuition plans, and it is much better than the mutual fund performance inside virtually every 529 savings plan in 2008. In addition to limitation on returns, the earliest that a certificate can be redeemed is 12 months after purchase. If you do a partial non-tuition redemption, you are going to want to contact your tax advisor prior to the redemption, because a partial non-tuition redemption doesn’t identify a specific certificate being cashed out, it is done on a pro-rata basis over all the certificates.
Time Limits – While time limits aren’t a huge issue for this type of planning, you do need to be aware of the key timelines outlined in the program. On the front end, the earliest redemption of a tuition certificate is 36 months after date of purchase. On the back end, the latest a certificate can be redeemed for tuition is 30 years after purchase. As previously stated, a non-tuition redemption can only occur after a 12 month lock-up period.
Ownership Transfer – Make sure whoever purchases the plan is the right owner for the beneficiary, because a major quirk in this plan severely limits the ability to transfer the ownership to another party.
Overfunding the Plan – It is unlikely that most people can or will fully fund the five-year undergraduate maximum that is allowed under the plan, but you should be aware that the sticker price on a private school isn’t always the price you pay. The majority of private schools will offer students some level of grant aid to attract quality students to their school. In addition, schools like Stanford can periodically eliminate tuition for families with limited incomes. As a consequence, it is a good idea to understand your means and circumstances before going gangbusters into the plan. Diversification with a quality 529 savings plan can make the investment more effective.
As with any prepaid tuition program, the devil is in the details. The Independent 529 is a plan that most advisors and parents have never evaluated for use in their college savings tool kit, but the plan offers a unique value proposition that warrants a thorough review if you are considering a private college for any of your children or loved ones. If your kid really is Princeton material, then you will not find a more reliable and consistent vehicle to help cover the cost of college tuition.