Is prepaying for college wise?

One way to start saving for a child's college education is through a tuition prepayment plan. Basically, a family pays an amount up front, either in a lump sum or in installments, based on current tuition costs for a college or university. The plan invests this money and, in turn, guarantees that it will cover the cost of tuition when the child enrolls years later--regardless of how high tuition costs may have increased during that time. Prepaid tuition plans typically are run by states. though some private institutions offer them.

One of the earliest prepayment programs was established by Michigan. The Internal Revenue Service initially ruled that the plan was not a tax-exempt organization and that its investment earnings would be taxed. In 1994, though, the Court of Appeals ruled that the IRS could not tax the plan's earnings. This decision probably will encourage more states to start similar plans.

However, parents should be aware that the IRS can tax the student (at his or her tax rate) on the difference between the amount the family pays into the plan and its value later when the student uses it to pay tuition. The IRS also can tax either the student or the parent (depending on the plan's contract) if there is a plan refund. The Treasury Department is considering regulations that could allow the IRS to tax a future student annually on any "imputed" interest earned by the plan, even though he or she does not actually receive the interest that year.

According to the Institute...