By Paula C. Brancato, Barnum Financial Group
The 529 college savings plan can be one of the most tax friendly tools available to fund your child’s future tuition, but how you approach investing the funds in your child’s plan can make a big difference in the potential return and level of risk.
529 plans do differ depending on the state that sponsors them. Most plans offer a selection of funding options. Investors can also choose an investment strategy and process. This article discusses 2 common investment processes you may employ, either on your own or with the help of your financial planner.
Neither is the better option, but 529 plan account owners should understand the differences, the potential impact on future account balances, and the risks involved. First, a definition of the plan itself.
529 College Savings Plan Definition
A 529 saving plan is an investment account that enables families to save for future college costs on a tax-favored basis. While contributions are generally not deductible, earnings can be withdrawn tax-free when used to pay for qualified education costs including tuition, fees, books and room and board.1 This includes college and graduate school expenses.
You may also access funds at any time for any reason. However, if you use these funds for other than education expenses, your earnings will be taxed and generally hit with an extra 10 percent penalty. The penalty is typically waived in the case of a death or disability, or if your child receives a scholarship.
If a child chooses not to attend college, you may change the beneficiary of the plan and pass any unused money in the 529 account along to siblings or other qualifying family members, tax and penalty-free. Of course, to maintain tax-free, penalty-free status, that money must still be used for qualified education expenses.
Most states do sponsor 529 plans and some offer a state income tax deduction or credit to residents who participate in their plan. New York, for example, offers a state tax deduction. You are not restricted to your own state’s 529 plan and may participate in any 529 plan you’d prefer. And, the money you accumulate in your plan can be used to cover costs at any qualifying college or university in the country.
By contrast, a 529 prepaid tuition plan is not an investment plan. Prepaid tuition enables you to purchase credits that lock in today’s in-state public tuition costs for your child to use in the future. Kids who select a private or out-of-state school can receive the equivalent of current in-state public college tuition – a credit — then pay the difference on their own.
Prepaid 529 college savings plans do not generate a return based on market performance. But they eliminate inflation risk as well as the risk of investing in the market. Now, for our 2 approaches.
Approach #1: The Age-Based 529 Model
For many parents, especially those who want to generate modest returns while managing risk, an age-based 529 investment model may be the best choice. An age-based strategy is a “set it and forget it” solution where your child’s funds are invested more heavily in stocks until your child reaches middle school. Then the “asset allocation” gradually shifts to include a higher percentage of cash and bonds, traditionally safer securities that may generate a lower return but with lower risk. (Past performance is, of course, no guarantee of future returns.)
Because an age-based plan automatically adjusts over time, it is an ideal approach for families who do not have the time and tools to monitor a 529 portfolio and make the necessary changes. An age-based strategy also helps minimize the risk of hitting a down market, just as your child needs to use his or her funds.
For those who have sufficient resources outside their 529 plan, or cash value in a life insurance policy they may borrow for college tuition expenses, an investing approach based on age might be too conservative.
Approach #2: Static 529 Plans
Experienced investors willing to assume greater risk in exchange for potentially higher returns may wish to select a static (or build-your-own) 529 investment plan.
An investor using a static approach will target a specific risk level or create an individual portfolio to track underlying mutual funds, exchange-traded funds or other investments. Asset allocation in such plans does not change over time, unless the account holder requests it.
Static plans are also the tool of choice for the highly risk averse; those who merely wish to put money into a relatively “safe haven” bond portfolio that is designed primarily to preserve principal (or their contributions) and not generate higher returns.
How Do I Select an Approach?
Families who are considering opening a 529 account should be sure the investment strategy they select matches their tolerance for risk and need for returns. For some families, the best solution is to diversify. Of course, you can change your 529 plan investment options over the years.
The most important decision you need to make is how much do we as a family want to save for my child’s education? Grandparents, friends and other relatives may contribute too!
One word of caution: Most financial planners agree that you should avoid borrowing from your retirement account to pay for your child’s college education, since scholarships and low interest loans exist for tuition assistance. Borrowing from an IRA or permanent life insurance policy might compromise your retirement goals or life insurance death benefits for your heirs.
New parents often have many competing financial goals, and a 529 plan may or may not be your optimal solution. A trusted financial professional can help you find a plan that best fits your needs.
1 Internal Revenue Service, “529 Plans: Questions and Answers,” 2016.
Paula Brancato MBA, CFP®, CEPA, CLTC is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. www.sipc.org 6 Corporate Drive, Shelton, CT 06484, tel: 203-513-6000. Paula may be reached at firstname.lastname@example.org or 646-813-9590
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The information provided is not written or intended as specific tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.