When it comes to saving for your family’s college education, a 529 plan is one of the best savings vehicles out there. Its high allowable contributions, tax-free growth and withdrawal for education expenses, as well as the control the owner can exercise over the account without it being included in their estate, make this a unique investment. The more common type of 529 plan is a state sponsored offering that includes a number of different mutual funds to invest in stocks and bonds. With this type of 529 plan, you have the opportunity to receive excess investment returns and growth of principal; however, there’s also the risk of losing money, like with any other stock or bond investment.
With the Private College 529 Plan, families can prepay tuition that can be used up to 30 years later at today’s tuition rates. The tuition certificates can be redeemed at one of the nearly 300 participating private colleges. These include schools like Stanford, Seattle Pacific University and Pacific Lutheran University, and the list keeps growing every year. The difference between the Private College 529 Plan and state prepaid tuition plans like the Washington Guaranteed Education Tuition (GET) program is that it has far more participating schools, and it’s not tied to a state’s budget or operations. The program can spread investment risk across all of the participating schools throughout the country.
How does it work?
Similar to prepaid tuition programs, you’re buying tuition certificates or units that are guaranteed for up to 30 years after the purchase date at all participating private colleges at the time of purchase. You don’t need to select a private school to attend up front, but you can choose five sample colleges to determine your child’s progress toward covering the tuition cost at those schools. Unlike traditional 529 plans that can pay all costs for college, this plan can only be used to pay for tuition and fees and any other required fees for enrollment.
Tuition certificates must be held for at least 36 months before they can be redeemed to pay for tuition. So if you buy a certificate when your child is a high school senior and they’ll be attending a private college the following fall, they’ll have to wait until their senior year of college to redeem the certificate for a full academic year.
Importantly, there are no annual fees or charges for enrollment in the plan. The proceeds from the tuition certificates are invested in a Program Trust managed by OppenheimerFunds, where the colleges share investment risk and expenses. The certificates can be used only for undergraduate studies, while traditional 529 plan assets can be used for undergraduate and graduate studies.
If a school leaves the program, they must honor the certificates purchased prior to their leaving. Certificates purchased after they leave the program can’t be redeemed at the school.
Below are examples of how this program works.
Example 1: Base case – Paying all tuition in advance
In this example, the beneficiary was born recently and has 18 years until they start college. At a 5% annual inflation rate, $10,000 in tuition today would cost $24,066 in 18 years. Since the tuition was guaranteed, the family didn’t have to take on any risk to meet the future tuition costs. The family prepaid four years of tuition at today’s rate, so $40,000 total. The graph on the right illustrates the difference in savings the family could have by locking in tuition rates now versus waiting.
Take Stanford’s $45,000 cost of tuition and fees and apply this math to it. With a 5% annual increase in tuition, it would cost $108,298 per year for tuition and fees alone to attend Stanford 18 years from now.
Example 2: Prepaying $10,000 a year for a preferred school that costs $30,000 a year today
Say that tuition costs $30,000 today. If you purchase $10,000 worth of certificates today (year 1), it would cover ⅓ of a school year’s tuition in 18 years if your child attended a private school that cost $30,000 a year today. Each year, if the tuition for that particular school or cost range went up by 5%, you’d receive slightly less tuition coverage, as the graph below shows.
Fast forward to year 3, where you buy $10,000 worth of certificates. That school’s tuition has gone up, though, and now costs $33,075 a year. So your $10,000 purchase would only cover 30% of a year’s tuition. Or even after 18 years of 5% annual tuition increases, a year of school at this particular college would cost $72,199. The $10,000 annual purchase would now only cover 14% of a year’s tuition. Once your kid starts school, the certificates can be redeemed to receive credit for how much of a year’s tuition they are worth (i.e., 33% + 31.75% + 30% + 14%) to determine if there is any shortfall.
Example 3: Your child attends a less expensive school
This is similar to example 2, where $10,000 of tuition certificates were purchased each year. Let’s say your child receives a $10,000 annual scholarship, or they go to a private school that costs $20,000 a year today, rather than $30,000. That certificate now is worth 50% of a school year’s tuition at the more affordable school.
If there are leftover tuition certificates after your child graduates from this school, you can either change the beneficiary, roll the funds to a traditional 529 plan or request a refund.
If your child had gone to a more expensive school that cost more than the certificates accumulated, then the difference would need to be covered by outside resources such as withdrawals from other 529 plans, parent’s cash flow, student loans, etc.
Example 4: Purchasing tuition certificates their senior year of high school
Let’s say a family saves in a traditional 529 plan while their child grows up. In the fall/winter of the kid’s senior year of high school, they receive an acceptance letter from the school they want to go to. This private college’s tuition costs $45,000. Due to the 36-month required holding period for the certificates, the first full year the student can use these certificates is in their senior year of college.
Since the investment mix shifts to being much more conservative when your child is close to entering college, being able to earn a 5% guaranteed rate for three years isn’t something you can find in today’s low interest rate environment. The year of tuition could be paid for through rolling over part of the traditional 529 plan tax-free into this plan. Keep in mind you’ll need to use some funds from your traditional 529 plan to pay for room and board, as the certificates won’t cover these costs.
How to contribute?
You can contributions as little as $25 a month to a maximum of $256,500. The maximum is based on the cost of five years of college at the most expensive participating college. You must also contribute a minimum of $500 within two years of opening the account.
Anyone can contribute to or open a 529 plan for your child. You can use the five-year rule to contribute $70,000 for each spouse without having to use up any of your gift tax exemption. A gift tax return must be filed in that year to elect five-year averaging.
Only the account owner, not the beneficiary, can make changes or redemptions to the plan. The 529 plan’s assets are also removed from the owner’s estate, thereby making this an attractive investment for a grandparent.
You can also roll over existing 529 plan assets from a state sponsored plan into this plan, without tax consequences.
What happens if your child doesn’t attend a private college?
Similar to other 529 plans, you can switch the beneficiary to another family member, roll the account to a state sponsored 529 plan or obtain a refund.
Certificates must be held for 12 months after being purchased before requesting a refund or rollover. Net annual performance of the Program Trust is subject to a maximum increase or decrease of 2% per year. If requesting a refund or rollover, the amount would be your original investment (cost-basis) plus or minus 2% each year based upon the Program Trust performance from the date of purchase to the request date. Any gains withdrawn for non-qualified education expenses are subject to ordinary income tax plus a 10% penalty.
Where it makes sense
This prepaid tuition plan makes sense for families who know at least one of their family members will attend a private college. It’s also a good solution for families who prefer the peace of mind of a guarantee. While we still believe in having more investment options, control and flexibility with a state sponsored 529 plan like the Utah Educational Savings Plan for the beneficiary’s younger years, this may be an attractive opportunity once your child is closer to starting school. Existing 529 plan assets that have accumulated could be rolled into the plan when your child is in high school to purchase certificates to lock in the tuition rate once you have a better idea of where they want to go to school.
Considering that tuition costs rise annually 4% to 7% and your child’s investment mix in high school becomes much more conservative, being able to lock in this guaranteed rate is appealing. In this interest rate environment, it’s hard to find low risk bonds that pay 3%, even without a guarantee.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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