Pre-paid tuition plans enable those saving for college to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board.

Prepaid-tuition plans come in two forms: state-sponsored and independent. Most plans are state-specific and designed for use with designated public colleges and universities.

For parents who intend to send a child to a private college, university, or other post-secondary educational institution, the Independent Prepaid Tuition Plan presents an attractive alternative. The independent plan is especially beneficial in states whose prepaid plan limits enrollment to only public schools or to colleges located only within that state.

Prepaid tuition plans provide many advantages, especially for higher income families that may not qualify for need-based financial aid, but they are not the best solution for everyone.

Before investing in a prepaid plan, parents should carefully evaluate the plan and their other investment options. From an investment perspective, a prepaid plan provides a low-risk, tax-advantaged investment, with earnings designed to match average tuition increases. This pace often does not happen, however, since tuition rates increase at about twice the inflation rate. A regular 529 savings plan offers a better opportunity to outpace the rising tuition rate.

Prepaid tuition plans are not necessarily the best way to save for college, but they provide a safe, affordable, tax-exempt option for families who may not be very knowledgeable about investing. They are a good option for families who want to pay for school and then forget about it rather than dealing with and worrying about market whims and risk.

Like other college-savings plans, prepaid-tuition programs offer a tax-advantaged investment. Withdrawals are tax-free when used for qualified higher-education expenses.

Prepaid plans can provide a hedge against economic downturns. During recessions and for a year or two afterward, state governments tend to reduce support for higher education. This change results in increases in public college tuition rates. So when other investments, such as mutual funds, fall with a declining stock market, prepaid tuition plans increase in value. A good diversification strategy for college savings includes a prepaid tuition plan in addition to other college saving programs.

Rollovers from a prepaid program into a 529 plan are allowed. For example, if the student decides not to attend college, the account owner can transfer funds to another eligible beneficiary, preserving tax advantages.

Refunds are also available if a student doesn't attend college or opts for a different school. State-run plans typically determine how much tuition your investment would buy, on average, at an in-state school. That amount is refunded in cash, less administrative fees.

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

If a student receives a scholarship covering all or part of the tuition and fees, the unused prepaid tuition benefits can be transferred to another member of the family, held for future use, or refunded.

There are a number of drawbacks to using a prepaid tuition plan.

Many programs charge premium rates over current tuition, so you end up ahead, but not by a great deal.

Prepaid tuition plans do not guarantee admission into college. Even if you buy the tuition ahead of time, students must meet academic entrance requirements.

State-sponsored and independent prepaid plans substantially restrict the number of schools available in a savings plan. Only a select number of schools participate.

Most state plans have residency requirements. Typically, state plans require that either the account owner or the beneficiary be a state resident. 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 charges.

One of the most significant challenges with a prepaid tuition plan is that while you lock-in tuition and lower your risk, you may actually save more by investing in a regular 529 savings plan. A 529 college savings plans requires the account holder manage the investment, similar to a 401(k), while the state or a designated financial services company manages prepaid plans, and returns are out of your control. This difference is not a huge problem, as prepaid tuition is guaranteed, but your money may do better elsewhere.

Refunds and rollovers are available if the student attends a school outside of a prepaid program, but the rate of return given on the invested funds is minimal.

Despite guarantees with a prepaid plan, shortfalls may still develop. Some plans let you save only for tuition, excluding room and board. More significantly, the plan itself could fail or close down. Many states have had to close or scale back their prepaid plans, as their investment returns could not keep up with the cost of tuition. A closure or a shutdown doesn't mean you lose money. Most likely, a state that ends its plan will still honor the tuition blocks purchased by participants. You would receive the original investment back, but it might not be enough to cover current college costs.

Prepaid tuition plans previously posed a problem with financial-aid formulas, making them a difficult choice for all but the most-affluent families. In the past, prepaid plans had a potential negative affect on financial aid. The prepaid portion was considered an additional resource, reducing need and affecting financial-aid awards. Beginning July 1, 2006, assets held in pre-paid tuition plans and college savings plans are now treated like 529 savings plans and Coverdell Education Savings Accounts. They're considered parent's assets, rather than the student's, which minimizes the impact on need-based financial aid.

Compare the effective return on investment of a prepaid tuition plan with the after-tax return on investment of alternate investments with FinAid's prepaid tuition calculator:

http://www.finaid.org/calculators/prepaidtuition.phtml

http://www.finaid.org

http://www.collegesavings.org

http://www.independent529plan.com