By Mark Jewell
AP Personal Finance Writer
BOSTON (AP) -- Shopping for kids can be tough. And if choosing among the dozens of options in the cereal aisle leaves you paralyzed, expect a far tougher time picking an investment savings plan for your child's college education.
An increasingly popular choice is the 529 college savings plan, which bears the section number of the federal tax code from which it was created. These investment accounts aim to ease the financial burden by allowing withdrawals for college expenses to be made free of federal taxes. Each plan is sponsored by a state which can set its own guidelines, including offering state tax deductions or credits to residents.
Investors aren't limited to investing in their own state's plan. Then there are fees and tax breaks to consider with 529 plans. Add a mix of investment options that vary widely from plan to plan, and it can all get quite confusing.
"A majority of people would say they have a really good understanding of their 401(k)," says Matt McCarthy, head of education savings at Vanguard, the largest manager of state 529 plan programs. "But we know for certain that a majority don't have a basic understanding, if any understanding at all, about 529 plans."
Successfully investing for college is all about building up a substantial cash hoard without leaving it vulnerable to the market's whims once enrollment is near. The plans generally take a conservative investment approach, emphasizing bonds in a child's teen years. Yet the array of investment options illustrates a wide range of thinking about the best way to adjust an account's mix of stocks and bonds over the years.
"A lot of parents don't have a good fix on how much risk they can stand," says Joe Hurley, a certified public accountant who founded Savingforcollege.com a decade ago, when 529s held less than $10 billion compared with today's $135 billion. "And people don't really understand the finer points of asset allocation."
Within an individual state plan, parents may face dozens of investing options, from conservative to moderate to aggressive portfolios, or selecting the mutual funds the account holds.
Before the stock market meltdown of 2008, Hurley says many parents didn't realize that their college student, or soon-to-be college student, was exposed to stock market losses through their 529 plan. Yet his company found that nearly nine out of 10 plan portfolios suffered losses, when major stock indexes slid nearly 40 percent.
Many states, and the private investment managers that most hire to run their 529s, have responded with new options to shield college savings from the next crash. For example, Indiana just introduced an option that's FDIC-insured against losses, and earns a variable rate of interest.
Although such plans offer protection, their conservative approach may yield paltry returns that won't keep up with college costs that have recently risen 5 to 6 percent a year, Hurley says.
You can enroll in plan on your own, or through a financial adviser at greater cost. With all the options, in many ways 529s have become more complex than 401(k)s, the workplace savings plans they're often compared with.
Here are key considerations in choosing a 529:
--In state or out?: Don't just sign up for your own state's plan, no questions asked. Many 529s are available no matter which state you call home. Find out what incentives your state offers beyond the federal tax perks Uncle Sam extends to all plans. If your child isn't yet a teenager, choosing another state's plan with lower fees or better investment options may pay off over the long run. That's even if you miss any potential state tax advantage. If you're already in a plan but have second thoughts, you can roll the assets over into another 529, without penalty.
--Leave rebalancing to the pros?: Most plans offer options where it's up to the investor to make any changes in the mix of investments the account holds. More popular are age-based 529s, similar to target-date retirement funds. They take a set-it-and-forget-it approach, automatically adjusting to fewer stock funds and more bonds over the years. With age-based 529s, the mix is typically more conservative and bond-oriented than with target-date funds. That's because a child has a relatively short span before college to recover from a stock market decline, compared with an adult saving for retirement. There's also less time for recovery in the few years a college student can expect to draw from the account, compared with the decades a retiree may need income.
--Bet big on stocks or small?: Many 529s offer portfolios for different degrees of risk, but investors can only switch once a year. Yet one provider's aggressive portfolio may closely resemble another's conservative version. Vanguard, for example, doesn't include stocks in its three portfolios for beneficiaries who are 19 or older. At that point, the portfolios are entirely in bonds and short-term investments like money-market funds. Yet the plans in Georgia and Connecticut, run by TIAA-CREF, hold 20 to 30 percent in stocks for those 18 and older, depending on which portfolio the investor chooses.
--What's under the hood?: To get a full picture, check what kind of stocks and bonds a plan holds, not just how much is in each asset category. One fund's stocks or bonds might be more volatile than another's -- for example, one might hold more in emerging markets stocks offering strong growth potential, while another emphasizes steadier domestic, dividend-paying stocks. The plans hold multiple funds, so it's a research challenge.
The good news is that states' efforts to reach better deals with outside managers running the plans have led to recent fee cuts at providers such as Vanguard, Fidelity, and T. Rowe Price.
The abundance of choices has also improved investment options, with fewer plans investing in so-so funds, says Laura Lutton, of Morningstar, which ranks 529 plans.
And investors can take comfort that the state governments are supposed to be consumer advocates when they hire companies to run 529s. "You've got to offer a decent plan," Lutton says, "before a state could hire you."
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Questions? E-mail the AP at investorinsight@ap.org.
Published: Thu, Oct 7, 2010
