529 college savings plans have their downsides
Sherri and Cliff Nitschke thought they were planning wisely for their children’s college educations when they opened a 529 savings account in 1998.
The Fresno couple saved diligently over the years in hopes of avoiding costly student loans. But their timing couldn’t have been worse.
When they needed the money a decade later, their 529 account had plunged in value during the global financial crisis. Their portfolio sank 30% in 2008, forcing the Nitschkes to borrow heavily to send their two sons to UCLA.
“529s were no friend to us,” Cliff Nitschke said. “Honestly, it’s probably one of the worst things we did. I could have made more money putting it in a mayonnaise jar and burying it in the backyard.”
Over the last decade, 529 savings plans have surged in popularity as parents scramble to keep up with rapidly escalating college costs.
Similar in some ways to 401(k) retirement plans, 529s are state-sponsored programs offering a tax-advantaged way to save for college. Parents typically invest in stock and bond mutual funds with after-tax dollars. But the earnings grow free of federal, and generally state, taxes.
Every state offers at least one 529 plan, and parents can invest in any state’s plan. Many states give up-front tax deductions for 529 contributions, though California does not.
Assets in 529 accounts have swelled to $135 billion today from $91 billion five years ago, according to Financial Research Corp.
But as the Nitschkes discovered, there are downsides to 529s that even careful investors can overlook.
“There are a number of pitfalls that can catch parents completely off guard,” said Deborah Fox, founder of Fox College Funding in San Diego, which advises families on how to pay for college. “They are not a panacea.”
The drawbacks include stock market volatility, strict limits on the ability to change investments and a small set of investment options. Experts say families with 529s must take active roles in managing their overall college savings plans instead of simply sinking money into a plan and forgetting about it.
Bear-market risks
A big risk is that the stock or bond markets will sink just as the first tuition bill arrives.
Especially when children are younger, 529 plans typically invest heavily in stocks because they have the best growth potential. But that can be a problem if the market struggles for an extended period, as it has in the last decade.
A study released this year shows how dramatic the effect can be.
A family that put away $1,000 a year in a fund indexed to the Standard & Poor’s 500 beginning in 1979 would have saved enough 18 years later to pay for 4.27 years at a public college or 1.84 years at a private school, according to the study by Education Sector, a nonprofit think tank in Washington.
But a family that put the same amount each year in a 529 plan beginning in 1990 and needed it in 2008 could have afforded only 0.72 of a year at a public school or 0.32 of a year at a private one.
The price of tuition
That’s due partly to rising tuition costs. But the stock market was a much bigger factor.
The Standard & Poor’s 500 index rose an inflation-adjusted 236% from 1979 to 1997, but it advanced only 14% from 1990 to 2008. Even if tuition had stayed the same, the student entering a public university in 2008 could have covered only 1.4 years, according to Education Sector.
“There’s this danger in people thinking that they’ve invested in a 529 and therefore they’re set and they don’t have to worry,” said Amy Laitinen, senior policy analyst at Education Sector. “Depending on where the market is when it comes time for their kid to go to college, and how much tuition has increased since they initially made the investment, the saving plan just may not be able to cover it.”
And though the danger is most acute in stock funds, some experts worry that investors who have huddled into the perceived safety of bond funds could suffer in coming years. If interest rates rise, the value of older, lower-yielding bonds will decline, probably lowering the value of many bond funds.
Making changes
The effects of the financial markets aren’t limited to 529s. Retirement accounts such as 401(k)s face similar problems.
But retirement savers can stay at their jobs longer or delay drawing on their retirement funds. Parents of college-bound kids have less wiggle room.
They can transfer a 529 to a younger child if they have enough cash from other sources to foot the bill for an older child. But they’re not allowed to later reimburse themselves from a 529 account.
And because a falling stock market is often caused by a sputtering economy, losses in 529 accounts often coincide with government cutbacks in student financial aid or rising tuition at state schools.
Many families use age-based funds that have large stock exposure when children are young and gradually shift to more conservative holdings as college nears. But 529 plans define “conservative” differently, and some mutual funds that parents thought were safe tumbled in 2008.
Several states, including California, responded in recent years by adding accounts that guarantee protection of principal. In today’s volatile market, families should shift to those offerings at least three years before they’ll start to need the money, Fox said.
A big restriction
Another downside of 529 plans, experts say, is an Internal Revenue Service rule that allows only one investment change a year.
That limits parents from yanking their money hastily during volatile markets. But it prevents a family that adjusted its holdings in March, for example, from switching to a more conservative portfolio if the stock market falls in September.
The rule snagged the Nitschkes and many other families during the financial crisis, handcuffing them from shifting to safer investments.
“It’s a huge shortcoming,” Fox said.
The IRS allowed people to make two investment changes in 2009, but most families already had suffered significant losses by then, and few people even knew the rule had been relaxed. The previous one-change-a-year rule went back into effect in 2010.
To maintain flexibility, families should make any desired changes by the end of the year, if possible, to leave the option open again the next year, experts say.
“If you make a change in January, you’re going to have to live with it until the next January,” said Laura Lutton, a 529 expert at Morningstar Inc.
Using Roth IRAs
Fox also recommends splitting college savings between a 529 and a second type of account, such as an individual retirement account in a child’s name. That would allow for investment changes when needed.
A child’s IRA can be used for college without triggering early-withdrawal penalties, and it isn’t reported as an asset on financial aid applications, thus avoiding the risk of a smaller aid package, Fox said.
One option is a Roth IRA, which allows tax-deferred growth for college. (That compares with tax-free growth for retirement.)
There is a caveat: Contributions must come from income the student earns, meaning parents can’t just seed the account with cash up front. But parents can pay children for household services as long as the wage is reasonable for the work performed, Fox said.
Many more investment options are available in an IRA than a 529. Investors in an IRA can buy virtually any kind of mutual fund, as well as other types of investments.
Meanwhile, 529s typically restrict investors to age-based funds and a limited set of multi-fund packages. Access to individual funds typically is limited to broad holdings such as S&P 500 funds. That prevents families from plowing all their money into risky emerging-market funds, for example, but it also keeps them from adding small helpings of specific funds they think may outperform.
“There’s a trade-off between making it fairly simple for investors to understand and making it more complex and comprehensive for more sophisticated types of investors,” said Paul Curley, a 529 expert at Financial Research Corp.
