'Safe' College Plans: 3 Things to Know

Updated on March 27, 2009. 

In an appeal to parents reeling from steep losses incurred in their 529 savings plans, several states are offering safer, government-insured investment options like savings accounts and CDs. But going the "safe" route may not be worth it for many college savers.

On Wednesday, Utah launched an FDIC-insured savings account in its Educational Savings Plan, becoming the sixth state to offer these more risk-averse investment options. (Each of the states allows nonresidents to contribute to their 529 plans. For more information on the individual plans, see our table below.)

At first glance, the investments sound enticing: With FDIC insurance of up to $250,000 per account this year (normally it’s $100,000), parents who put their kids’ college savings in a savings account or CD can rest assured that the money is protected from market meltdowns. And, with that investment as part of their 529 plan, they still get the benefit of tax-free growth if the money is used for college expenses.

The "safety" pitch seems to be working. During the fourth quarter, College Savings Bank, which manages Montana and Arizona’s Family Education Savings Programs, saw rollover contributions jump 625% from the previous quarter to $1.6 million. In Virginia, money deposited in savings accounts at Union Bank & Trust, which partners with its 529 program, has nearly quadrupled since the end of June. Ohio’s program, which had accumulated $96 million between its launch in September 2005 and March of last year, had almost twice that amount -- $179 million -- on March 26. And in the seven weeks since its inception, Utah's FDIC-insured savings account has attracted $19 million in new funds or from investment option changes.

Yet, as attractive as guarantees from the government in a time of economic turmoil may seem, these savings options don't make financial sense for many investors. Here's what you should know.

With low risk come low returns. Because the money contributed to a savings account or CD is invested in low-yielding products, such as Treasury bonds, the returns on these products can be as low as 1%.

Granted, if you have a short investment horizon -- say your child has just two or three years before they head off to college -- then it's best to try to preserve your principal rather than hope for high returns. But if your child won't be leaving the nest for five years or more, you could actually lose money by investing in a low-yielding plan, says Greg Brown, fund-research firm Morningstar’s lead analyst for 529 plans. Investing in equities, he says, would be a much smarter option. “Over the long term your biggest enemy is [the] 8% inflation rate of college expenses,” he says. “If you’re not keeping up with college inflation, you’re actually losing money.”

With the market still way off its 2007 peak, you may be tempted to roll over your 529 savings plan assets from equities into one of these new government-insured investments. But by pulling your money out now, you’re locking in losses that can run as high as 40%, says Brown. And when the stock market recovers, you’ll miss out on what will likely be much stronger returns than those offered by a CD yielding 3%.

“If you think this is the bottom of the market, then the last place you want to put your money is this investment,” says Andrea Feirstein, an advisor to 529 plans.

With 529 savings plans, investors are only allowed one investment change per calendar year (this year, the IRS made an exception, allowing two changes). That limit also applies to rolling over funds from a matured CD to a new one, says Feirstein.

So if you like to spread your contributions, purchasing CDs several times throughout the year, you might be out of luck. If you purchase three CDs with the same maturity at three different times within a calendar year, for example, you won’t be able to roll over the second and third CDs into new ones when they mature. In other words, you may have to make one lump-sum contribution to a CD per year, or time your CD purchases so they mature in different calendar years.

Some states have found ways around this hurdle. Ohio’s program, for example, automatically rolls the money over to a savings account at maturity, so those who have used up their investment change option can wait until the next year. College Savings Bank has set up what they call “a path to college” that automatically rolls over CDs into the same maturities or shorter, depending on how long the beneficiary has until they start college. Sticking to those paths isn’t considered an investment change, says Dan Davenport, a spokesman for the bank. And Wisconsin’s plan is set up so that investors purchase shares in CDs that can be liquidated at any time. The plan owns the CDs and holds them to maturity, while distributions are made from a cash reserve. But that liquidity comes at a cost: There’s a 0.36% management fee, eating into CDs’ already-modest returns.