As many Americans scrounge for holiday deals, they might consider plunking those dollars saved into a college-savings fund for their children or grandchildren. But what’s the best place to park money that needs to grow at a rate to keep up with rapidly rising tuition costs?
It might be a 529 plan, where tax-free earnings can give you an edge. But the plans aren’t all created equal.
A 529 college-savings plan allows you to invest money for a family member that you later withdraw income-tax-free to pay for the relative’s education costs at almost any accredited college, community college or vocational school. It’s funded with after-tax money but grows tax-free to cover qualified items including tuition, room and board and textbooks.
You can change the beneficiary at any time — even using the funds to pursue your own education — and you’re not limited to the plans available in your home state. Also, the plans have an advantage over traditional college-savings vehicles: In the federal financial-aid calculation, investments held in a grandparent’s or parent’s name are generally treated more favorably — that is, they tend to reduce financial aid less — than student-owned funds.
Assets in 529 plans have ballooned to $119 billion this year, according to a recent report by investment researcher Morningstar Inc. That’s up from $200 million in 1998, the year after they were created. All but three states offer at least one plan, with 82 plans available nationwide.
If you’ve been putting off considering one for your child or grandchild, you might want to think again. Fees are coming down, and while the typical 529 plan lost almost 24 percent of its value in the 2008 market crash (compared with a 37 percent dive for the S&P 500 index), many have eked out more gains than their mutual-fund counterparts in the past five years, according to Morningstar.
“Even though 529 plans tend to be more expensive than mutual funds, they have outperformed (mutual funds) over the past five years,” said Laura Lutton, editorial director in the mutual-fund research group at Morningstar in Chicago.
Overall, 529 plans slightly outperformed open-end mutual funds in five of seven investment categories Morningstar measured. In the large-growth arena, 529 plans returned an average 1.01 percent in the five years ended Sept. 30 compared with an average 0.68 percent return for open-end mutual funds.
In the moderate allocation category — defined as funds with between 50 percent to 70 percent in equities and the rest in bonds and cash — 529s had an average five-year return of 2.54 percent versus 2.29 percent for mutual funds.
Where 529 plans lag their mutual-fund counterparts, higher fees are often the reason, particularly with fixed-income funds, the Morningstar report said, adding that those lower returns may be offset by state tax breaks on some 529 contributions.
Some 529 plans that, like target-date retirement funds, shift their investment strategy over time based on the beneficiary’s age, saw relatively strong returns, Morningstar found. For instance, the age-based SMART529 West Virginia Direct College Savings Plan, for that state’s residents, and the Franklin Templeton 529 Plan based in New Jersey both saw 5.84 percent annualized returns over the five years through Sept. 30.
Many 529 plans have lowered their fees in the past year or two, especially the direct-sold variety.
The typical cost for a direct-sold fund is now about 0.25 percent, down from about 1 percent for many plans, said Joseph Hurley, founder of SavingforCollege.com, a website with 529-plan information, based in Pittsford, N.Y.
“They’ve reduced expenses in two ways: They’ve reduced their program fee and gone to cheaper mutual funds — in many cases, gone to index funds,” he said.
And since the 2008 market meltdown, some 529 plans have added bank products insured by the Federal Deposit Insurance Corp. for people who prefer the relative safety of cash, Hurley said.
“A lot of people are saving for college in bank savings accounts,” he said. “If that’s what you’re looking for, why not at least do that without having to pay taxes on the interest?”
Still, the pitfalls of having a 529 plan include fees, market risk, limited investment options and the ability to change allocation just once a year, Hurley said. And if you end up needing to withdraw the money for purposes other than education, you’ll face a tax hit and a 10 percent penalty on the earnings, he said. In that case, “you might have been better off from the start in a taxable investment account rather than a 529.”
Selecting a 529 plan to meet your needs can be challenging, Lutton said. Investigate the options in your home state first, regardless of where the child hopes to go to school.
“If you live in a state that has a great plan and some tax advantages to investing there, it’s not a hard decision,” she said, “but if the plan is not best-in-class or you don’t have any in-state tax advantages, then you’ve got to weigh a complicated set of variables.”
Among them: Do you invest directly or go with an adviser-sold plan? Are the fund’s fees, performance and management team up to snuff? Is there an initial minimum investment? How much time do you have before your child will need the money?
Age-based 529 plans, similar to target-date retirement funds, have given some families peace of mind. But choosing one doesn’t give you license to set it and forget it, said Kimberly Foss, a certified financial planner and president of Empyrion Wealth Management in Roseville, Calif.
Dig deep to see how the age-based options allocate their resources between stocks and bonds, she said, because it may be difficult to recover from losses in those critical years immediately before your child starts college. For instance, a “conservative” investment option with 30 percent in stocks may not meet your criteria.
When the child is about 16 years old, “you really want to make sure your allocation is 90 percent fixed income or short-term bonds,” she said.
Still, even the professionals haven’t forged a consensus on what the appropriate mix of investments is for a student entering high school.
Some savers might see tuition inflation as the greater risk and seek growth to offset cost increases even if it means sacrificing some money in a market downturn. Others may view stock-market risk as the bigger threat and opt for an approach that focuses on principal preservation.
Either way, college costs don’t appear to be coming down anytime soon, underscoring the need to start socking away money as early as possible to take advantage of the value of compounding. In the past decade, tuition and fees at public four-year schools grew at a 5.6 percent annual rate, according to a 2010 report from the College Board Advocacy & Policy Center.
The list price for in-state tuition and fees at public four-year colleges and universities averaged $7,605 for the 2010-2011 academic year, almost 8 percent higher than last year, according to the report. At private, nonprofit four-year institutions, published costs averaged $27,293, up 4.5 percent from last year.
Morningstar recently rated 52 of the larger 529 plans based on performance, price, confidence in the management team, stewardship practices and underlying investment quality. Five plans cracked the top category for 2010, according to the report released Nov. 1.
Two direct-sold plans from T. Rowe Price got top honors, the T. Rowe Price College Savings plan based in Alaska and its Maryland College Investment Plan. They’re run by long-tenured managers, and the age-based funds are run by the asset-allocation team that also does their target-retirement funds, Lutton said.
The Vanguard 529 College Savings Plan in Nevada also made the list of top funds and had half the annual fee of a rival Nevada plan from UPromise, which was one of three to receive a below-average rating.
“Particularly when you’re talking about indexing, we think it really pays to be cost conscious, and the Vanguard plan out of Nevada stood out in that regard,” Lutton said. Still, the Vanguard plan has a $3,000 minimum investment requirement, much higher than many other plans.
Morningstar analysts rated Ohio’s CollegeAdvantage 529 Savings Plan, a direct-sold option with an expense ratio of 26 basis points, tops as well. “We think they’ve done a nice job giving a variety of investment choices in a plan with a very reasonable price tag,” she said.
CollegeAmerica, a broker-sold fund in Virginia, rounded out the top five. It features American funds exclusively and is the largest 529 plan, Lutton said.
The CollegeBoundfund, the Rhode Island plan managed by AllianceBernstein, ranked bottom this year, largely due to what Morningstar views as high manager turnover at the parent fund company.
“The primary concern is the churn we’re seeing among senior personnel at AllianceBernstein,” Lutton said. “We think when you’re making a long-term commitment like you do with a 529 plan, you want to make sure the management team is going to be with you.”
Patricia Roberts, senior 529 product manager with AllianceBernstein Investments Inc., said the bottom rating for its Rhode Island plan came as a surprise.
“We’re puzzled that Morningstar’s own analysis seems to contradict its conclusion about the CollegeBoundfund,” she said. “We’re actually ranked quite favorably in the categories they analyzed.”
It may not be what family members preparing to play Santa Claus to younger relatives want to hear, but giving children a financial contribution toward future college costs makes sense, said Foss, the certified financial planner.
Some 529 plans offer coupons you can print out and include in holiday greetings or birth announcements that make it easy for loved ones to donate to a child’s plan. The coupons are especially handy for parents of babies and young kids, who often receive more toys than they can use or store.
There’s a tactful way to ask people to balance their toy-buying joy with a 529 plan contribution, Foss said.
“You can ask your parents and family members (to) just buy a little toy for $5 and take the other $20 and write a check to the 529.”
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