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Related topics: college costs, tuition, education, savings plans, Liz Weston

Do you dream about sending your toddler off to college someday, but worry about the spiraling cost of a college education? There's a solution: Prepaid tuition plans that promise to lock in tomorrow's college costs at today's prices.

Under such plans, families are allowed to purchase blocks of tuition that can be used later at one of the plan's covered schools. If tuition rises after you've purchased the blocks, it doesn't matter: A semester purchased now will still buy a semester's worth of tuition 10 or 15 or 20 years from now.

Prepaid plans still have their drawbacks. They're best-suited for novice or conservative investors, because those willing to take moderate risks probably will end up with more money for college by investing in a 529 college savings plan or other portfolio that invests in stocks.

And, despite being marketed as a "guaranteed" way to save for college, you may still fall short with a prepaid plan. Some plans let you save only for tuition, not room and board. More significantly, the plan itself could fail or close down. You would get your original investment back, but that might not be enough to cover college costs. More on this risk later.

Image: Liz Weston

Liz Weston

But with the cost of tuition rising faster than the rate of inflation, you should at least explore prepaid plans before deciding on a college-savings strategy.

"Prepaid plans are good for families who want to pay for it and forget about it," said Joseph Hurley, a CPA who runs the Savingforcollege.com website.

How the plans work

Prepaid tuition plans are cousins to the more popular, state-run college savings plans. Both are known as 529 plans, after the IRS code that allows them. Like other college savings plans, prepaid tuition programs allow you to save for school in a tax-deferred investment. Withdrawals are tax-free when used for qualified higher-education expenses.

Both types of accounts get favorable treatment for financial aid purposes. They're considered the asset of the parent, rather than the student, which minimizes their effect on need-based aid.

But whereas college savings plans require you to take all the investment risk -- much like a 401k retirement plan does -- prepaid plans are designed to take the investment risk off your shoulders (rather like a traditional pension).

"A family that does not want to take on market risk with stocks and bonds may prefer the relative safety of a prepaid plan," Hurley said. Prepaid plans are typically a better bet than the low-rate, "guaranteed" options in college savings plans, which "may not offer much hope of keeping up with tuition."

Prepaid plans tend to work better for families with younger children than those whose kids are already in high school. Grandparents and others can contribute, too.

"Many programs charge a premium over current tuition," Hurley said, "and you need time to recoup the premium through tuition increases."

State-school vs. private-school plans

In the state-run plans, the blocks typically can be used at any of the state's public colleges and universities. The price of the blocks is based on a weighted average of current tuition at those schools.

In the private plan, known as the Independent 529 Plan, prepaid tuition can be used at any of several hundred participating colleges -- a list that includes Amherst, Smith and Wellesley colleges and Stanford, Tulane, Notre Dame and Princeton universities. Even if you buy the tuition ahead of time, your child still must meet academic entrance requirements.

Investors buy certificates that represent a different percentage of tuition, depending on the school. The same certificate might pay for 50% of the tuition at a less expensive school, for example, but only 20% of the tuition at a pricier college.

If your student doesn't enroll in a covered school

There are provisions if your child doesn't go to one of the covered schools. The state-run plans typically determine how much tuition your investment would buy, on average, at an in-state school. They give you that refund in cash, minus any administrative fees.

The private plan refunds an amount equal to your original investment, adjusted by the performance of the trust in which the money is invested. That adjustment is limited to a maximum annualized gain or loss of 2%.

Here are some other key points about prepaid plans:

  • State plans may have a residency requirement. Typically, state plans require that either the account owner or the beneficiary -- the kid who'll be using the money -- be a state resident. (The private plan has no residency requirement.) If your family moves out of state, you'll still be able to use the money at an in-state institution, but you may be responsible for any nonresident tuition or fees that the school charges your child.
  • Not all states offer prepaid plans. Some that do are closed to new investment. Other states offer a guaranteed investment option as part of their college savings plan: Investments in the plan are guaranteed to keep pace with tuition. Scout state plans at CollegeSavings.org.
  • You can transfer the money. In addition to refunds, you're allowed to transfer your prepaid plan balance to another 529 plan, including another state's prepaid tuition or college savings program. That allows you to preserve the tax advantages.
  • There's no guarantee a plan will be around when you need it. The conditions under which a prepaid tuition plan would be most useful are also the conditions that threaten the plans' survival. Twice this decade, prepaid plans have been hit with a one-two punch: A recession that strangled the states' budgets also resulted in lower investment returns in the prepaid tuition plans. The shortfalls have caused plans in some states to close enrollment to new participants or to close permanently.

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A closure or even a shutdown doesn't mean you would lose money. Most likely, a state that ends its plan will still honor the tuition blocks purchased by participants. At worst, you would get a refund. But you'll want to monitor your plan's health and have a Plan B in case its finances get shaky.

Still intrigued by the idea of buying tuition in advance? Savingforcollege.com has more information on prepaid plans, as does FinAid.org, another website focused on ways to pay for college.

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.