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Do's and Don'ts for Using a Prepaid Tuition Plan

Read the prepaid tuition contract and don’t forget to declare contributions on your taxes, experts say.

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Prepaid tuition plans aren't foolproof. While this kind of tax-advantaged college savings account allows parents to save on college costs by buying tuition years ahead of time, there are common mistakes for parents to avoid.

For instance, parents with prepaid tuition plans, a special kind of 529 plan, sometimes purchase too little tuition because they don't realize they can use an installment plan to spread out the cost.

To avoid other common mistakes and get the most out of a prepaid tuition plan, experts offer the following do's and don'ts for families.

[Determine if a prepaid tuition plan is right for you.]

1. Do read contracts: Read contracts to find out what exactly is covered and to keep up with statements. Often families who buy a four-year plan think they've fully funded all college costs, says Joan Marshall, executive director of the College Savings Plans of Maryland.

"Room and board costs are not typically part of a prepaid plan," she said via email, although at least one plan – one of Florida's state plans – has a separate room and board component as part of a prepaid plan.

She recommends parents save for room and board expenses in a separate, traditional 529 plan account.

2. Don't forget to declare contributions on state tax returns: Like traditional 529 plans, withdrawals are exempt from tax. Contributions can also qualify for state tax deductions and credits.

"Most people are not aware that prepaid tuition plans are 529 plans also," says Marshall.

Prepaid tuition plans have the same benefits of traditional 529 savings plans, such as no taxes on the increase in value of the tuition credits, as tuition is what's known as a qualified higher education expense.

3. Don't cancel the contract prematurely: If your teen gets a full scholarship, he or she doesn't need a plan that covers tuition and fees. But what happens if students lose academic scholarships because of a drop in GPA or withdrawal from courses, or lose athletic scholarships because of injuries?

It's important to know how long a scholarship will last as well as the reasons it could be cancelled, says Nevada State Treasurer Kate Marshall.

"In case they lose it, you have the prepaid program with locked-in benefits to fall back on," she says.

[Avoid these common college savings mistakes.]

4. Do consider installment plans for younger children: Installment plans allow parents to purchase future tuition at today's prices and then divide the total cost among equal monthly payments.

"The sooner you establish the account, the lower the monthly payments since the plan allows you to stretch payments out until the beneficiary turns 18," says R.J. DeSilva, a spokesman for the Texas Comptroller's Office.

For instance, purchasing $4,000 in tuition credits with a monthly payment plan that charges 8 percent interest would cost $50 per month for 10 years. If the same dollar amount of tuition credits are purchased when the student is a freshman in high school, the payment would jump to nearly $100 per month.

Plus, the younger student would likely save more on tuition and fees, since the tuition rate would likely be higher when they begin college than it would for students only four years from starting school.

[Don't fall for these prepaid tuition plan myths.]

5. Do keep address information up to date: You could miss a statement, an important plan change notice or a payment notice for an installment plan and incur late fees, says Nevada's Kate Marshall. For extra protection against late fees, she recommends setting up an automatic recurring payment.

Above all, stay informed, experts say. Prepaid tuition plans are a great way for parents to save early for future college costs, but require staying diligent about understanding terms and planning future contract redemption.

Trying to fund your education? Get tips and more in the U.S. News Paying for College center.