Our age-based funds aren t even close to precise.
Chris Pinney s oldest son was a freshman in college when the market tanked, wiping out 20% of the balance in his 529 plan. The loss came as a shock. The San Antonio, Tex., veterinarian had relied on age-based asset allocation funds, which are supposed to grow more conservative as a child gets closer to college. But the plan was still heavily invested in stocks when college arrived and once Pinney realized it, it was too late.
Financial advisors like to recommend age-based funds because they are supposed to capture the growth (and risk) of stocks when college is far away, and get gradually more conservative, says Joe Hurley, founder of SavingforCollege.com. But conservative means different things to different plans. Even in a single state s plan, the funds designed for a high school senior might vary from 0% stocks to 40%, as it does in North Carolina. Utah s plan is even more diverse; funds for 16-year-olds include an option that allows for up to 50% exposure to stocks.
Your investment options are limited, and your returns are too.
When John Connell opened 529 accounts with his home state of Wisconsin for his three daughters, the plan offered only mutual funds from Strong Capital. He wanted the tax advantages associated with his state plan, but he was disappointed by the funds, which underperformed the market by around 5% for the first two years he held them. The plan eventually added other funds after Strong s founder was accused of improper mutual fund trading in December 2003 but by then, Connell s oldest daughter was already in college.
Connell s experience isn t unique. Most 529 plans fewer than 15 investment options, which limits the success an investor can have, says Hurley. International investing options are notably lacking: Around 70% of assets in 529 plans have domestic exposure, according to Morningstar. Also missing are some of the safest choices, like certificates of deposit or other principal-protected options, which are currently offered by 14 state plans, according to the College Savings Plans Network. The options aren t growing, either. There are 1,750 funds in 529 plans, according to CSPN, down 7% from the number of offerings in 2008.
You ll lose a lot to fees.
After the birth of their daughter Katie four years ago, John and Theresa Jordan took the standard financial planning advice and set up a 529 plan, managed by Calvert. And though its performance has been all right with returns around 5%, they re handily beating the S&P 500 Jordan s grown weary of the fees he pays: $15 per year, plus a 0.15% management fee. Between the returns and the fees, you end up not really making a lot, he says. Worse, the 529 plan he opened for his niece four years ago is down more than 18% -- and carries a 0.5% annual fee.
When it comes to fees, advisor-sold 529 plans, which comprise 46% of the market, are the most expensive. As an alternative, invest with a direct-sold 529 plan, where fees are at the lowest they ve ever been, says Paul Curley, a research analyst at the Financial Research Corp. Annual fees dropped to 0.61% in August, down from 0.71% just eight months before, according to the FRC. Meanwhile, the average fees for A-shares in advisor-sold plans have stayed basically flat, at 1.17%.
Save $100,000, but lose $5,640 in financial aid.
The last thing a parent wants to hear after toiling for years to save for college is that they ll be penalized for that very act. But when students apply for financial aid, their 529 plan whether it s in their name or their parent s name counts as an asset, which means they re eligible for less help, says Mark Kantrowitz, founder of FinAid.org. The student s financial aid package will be smaller by up to 5.64% of your 529 plan s balance. So if you have $60,000 in a plan, you ll receive $3,384 less in financial aid for that year. (That will change each year depending on how much you have in your 529 plan.) Of course, coming out $57,000 ahead probably outweighs the aid money lost but few plan providers offer this information upfront.
Help from family or friends hurts, too. Say grandparents (or aunts, uncles, friends) hold on to the 529 plan and withdraw $30,000 for a child s college expenses. The next year, when the student returns to college, he ll lose $15,000 in financial aid or half the amount of the 529 plan distribution, says Kantrowitz. That s because, according to financial aid rules, distributions from a 529 plan owned by a third party are considered income and therefore more heavily assessed by the government guidelines for financial aid. By contrast, if the student or the parent owns the 529 plan, the money is considered an asset.
Stash your money in a savings account if your kids are in or close to attending college.
Connell s two youngest daughters now 23 and 24 were in college when the market downturn hit, and their Wisconsin 529 plans each dropped by more than 20%. He and his wife watched as seven years of savings dwindled. It s not like the universities said, You can give us the money when the market turns around, he says. Fortunately for the Connells, they had diversified their college savings and were also saving in a private prepaid tuition plan that they were able to use.
The Connells experience shows how crucial diversifying is, particularly when students are a year or two away from college and once they re enrolled. Given the ongoing market volatility, parents might want to transfer some money in their 529 plan to the safest options available in it, like a CD or savings account, says Deborah Fox, founder of the financial-planning firm Fox College Funding. That way, even if the market takes another dive, you ll have at least a year s worth of college tuition that s been safe. Another option might be to stash money outside of a 529 plan in a savings account or another principal-guaranteed investment; while the return will be low, that money will be safe in case of new market losses. The downside, of course, is that this lower return probably won t keep up with the rate at which tuition is rising and you could miss out on bigger returns from the stock market.
There are more loopholes than you know about in prepaid plans.
As more parents try to save for college and avoid the stock market at the same time, interest in prepaid tuition plans has been rising. The programs, which let parents buy units or semesters at today s tuition prices, now make up 13% of college savings plans, up slightly from 12% from two years ago, according to AKF Consulting, which assists state governments with 529 plans. Originally limited to public universities, prepaid plans have expanded to private schools. Now, through the Private College 529 plan, parents can lock in today s cost of tuition at 272 private colleges in the U.S., including Princeton and Stanford.
But if a student doesn t attend the precise public university, or one of the schools in the prepaid pool, or any college at all, the parents lose. If you bought in-state units and your child attends an out-of-state public college, you ll have to pay the difference in tuition from your in-state plan at the current prices. If you bought into the private prepaid plan, but your child ends up with a full scholarship, say, you ll get your money back, plus or minus 2%, depending on how the underlying investments in the plan have performed. In the best case scenario, it s a return most savings accounts would have offered or it s a loss.
If Junior is an All-American or a brainiac, say good-bye to your money.
An extra $40,000 sounds like a good problem to have. Not when that money is stashed in a 529 plan. That s Dr. Pinney s dilemma. His three children are all in college, but because they ve received scholarships that cover most of their tuition, he s left with a sizeable balance that s locked up in their 529 plans.
What can he do? If Dr. Pinney withdraws this money without using it for college education, he ll have to pay federal income taxes on any earnings, plus a 10% tax penalty the same fees he d pay to withdraw the cash if his kids had skipped college altogether. To make sure the money is used at face value, the Pinneys would have to use it fund their own educational pursuits, or give it to a close relative (by changing their plan s beneficiary).
Those state tax breaks? They aren t worth much.
Parents often choose a 529 plan offered by their home state because it offers a tax deduction or credit the higher the state s marginal tax rate, the higher the tax savings, says Hurley. But that tax break may not be big enough to offset losses from low returns or high fees. The average total net contribution was $1,359 in 2009, according to the Financial Research Corp. and the College Savings Foundation. A parent in a high-tax state like New York, where the marginal tax rate is 6.85%, who invests $1,359 will end up with a state income tax deduction of $93.09 small beans considering the investment. In Maryland, where the marginal tax rate is 4.75%, a resident would end up with $64.55.
There are better ways to save for college.
For parents who qualify, a Roth Individual Retirement Account may be better than a 529 plan. Parents can open these accounts anywhere, including a bank or discount brokerage, and they can invest in many options mutual funds, ETFs and individual stocks and bonds. And unlike a 529 plan, parents can withdraw their contributions at any time, for any reason (it s the earnings that can t be withdrawn without penalty until age 59-1/2). Some people might adopt a strategy of withdrawing some of their principal for college costs, and keep earnings in Roth until retirement, says Hurley.
Even if you use a 529 plan, there are ways to diversify and add to the pot. A Coverdell education savings account offers more investment options, including individual stocks and bonds, the money grows tax deferred, and it isn t limited to college it can also be used for elementary and secondary school. Contribution limits are lower, though, at $2,000 per child per year. (However, if Congress doesn t extend some of the Coverdell s provisions by the end of the year, parents won t be able to use the money for kindergarten through 12th grade education and the contribution limit will drop to $500.) Also, parents who use credit cards for most purchases can earn rewards cash for college expenses by signing up for Sallie Mae s Upromise credit cards. Both offer rewards on groceries, while one also has rewards for gas and the other for dining. Of course, the amount you end up earning on average $117 a year might be only enough to cover the smaller expenses, like some books, fees or campus parking.
Your assets can be seized if you declare bankruptcy.
Around 1.5 million people filed for bankruptcy in the year ending June 30, according to the latest data, and when creditors come to college, funds in a 529 are fair game if the plan is less than two years old. Following the two-year period, your plan is safe if the beneficiary is your spouse, child or grandchild, says Hurley, but if you were saving for your own education if you re the beneficiary creditors can come after it regardless of how long you ve been saving. Some states, like Colorado, Florida and New Jersey, protect 529 plans from creditors in some cases. Those protections are usually valid if the 529 plan is with the state where you live, and you meet other requirements.