Prepaid-tuition plans might be on shaky ground

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Section 529 prepaid-tuition savings plans are useful if you want to lock in the cost of college early. However, backfired investments (courtesy of the recession) and tuition hikes have prompted at least one lawsuit over tuition payments. A parent group in Alabama filed suit—pending at press time—after the plan administrator announced that it would pay tuition and fees only at 2010 rates.

Tennessee’s plan was so underwater that the state gave it a $41 million bailout in 2010 and then closed it to new investors. In fact, nine of the 20 states that have prepaid-tuition savings plans are closed to new investors, says College Savings Plans Network. (Because tuition increases outpaced investment returns, closing the plans to new investors is seen as a tactic for the plan to stay solvent.)

If you’re considering or already are enrolled in a state prepaid-tuition plan, you should read your plan’s disclosures to determine its projections of how fast that tuition will rise and how the program invests, David Rayfield says. Rayfield is an attorney for the Alabama parent group that’s the plaintiff in the pending case. The Alabama plan’s investments, for example, have to earn a 9 percent return per year to be self-sustaining, he says. Rayfield notes that, according to the plan’s actuary, 5 percent is a more realistic return.

Every plan’s obligations and forecasts differ. Typically, he says, you should look for a plan that doesn’t put everything in low-risk investments (to meet current tuition payments) or aggressive stock investments (to meet future obligations).

If you’re unhappy with your prepaid-tuition plan, you might be able to roll that money over into a traditional 529 college-savings plan without incurring any tax penalties.

T. Orem