When choosing funds for your college 529 plan, don’t make this mistake
The average cost of public in-state college tuition, extra charges, room and board in 2020-21 is $26,820 a year and $54,880 for a four-year private college, according to a recent study by the College Board. For a child born today, the four-year cost of college is expected to be $526,629 for private and $230,069 for public, according to a recent study by J.P. Morgan. Imagine if you have two or three kids?
True, there is financial aid, merit and athletic scholarships. Most schools discount the sticker price. But there is no guarantee your child will receive aid, so we must plan. Sadly, most parents lack a plan for college savings. They have good intentions and care for their kids, but for one reason or another they never get around to setting anything up. Parents who say they do “have a plan” often are merely throwing some money aimlessly into an age-based 529 college savings program. That is a good start, but not enough to meet the six-figure future cost of college. Planning that expense requires a thoughtful, meticulous plan.
For my clients, we start with reviewing their goals and objectives. We review the expected cost of public and private college in their home state. Then parents may decide to try to cover 100% of college costs, 50% or maybe a third. Having a goal in mind is extremely important. It creates motivation and lessens anxiety. We then review their monthly cashflow to find a number they feel comfortable allocating into a college savings program. From there we devise a holistic plan. We review their employer plans, such as deferred compensation or company stock plans, insurance needs and expenses, discuss retirement savings, inheritances and anything else that’s important to the conversation. We then review several college saving recommendations.
Here is one: Forget age-based options.
How parents fail to make the most of 529 plans
You probably are familiar with the 529 college savings plan. These programs are a solid choice for college savers. Contributions are after-tax, earnings grow tax-deferred, and withdrawals for qualified higher-education expenses (room, board, tuition and some charges) are income tax-free. In addition, assets in a 529 plan receive preferential financial aid treatment when owned by a parent. A maximum of 5.64% of parental assets count toward a family’s Expected Family Contribution (EFC) when applying for federal financial aid versus 20% of a student’s assets. There are penalties for not using 529 money for college, namely a 10% penalty on withdrawals, plus the earnings are income taxable.
Many parents are familiar with 529s, but many don’t fully utilize the program. In practice, many parents contribute monthly to a 529 into an age-based mutual fund, which on the surface seems logical. An age-based mutual fund invests in more aggressive equity mutual funds for younger children, then automatically shifts to more conservative bonds as the child ages and gets closer to college. This makes sense, as you want 529 money to be conservative as the child gets closer to withdrawing the money for college. Age-based funds are set-it-and-forget choices.
However, age-based mutual funds can also be too conservative. For example, some age-based mutual funds own some bonds for all ages, starting at age zero. This means a newborn, 18 years away from needing the money for college, has some conservative, low-yielding bonds in the account.
Asset allocation is important, of course, and bonds play an important role in helping a portfolio weather a stock market storm, as they usually hold up better in a stock market crash. But a newborn child has a long, long time before needing the money for college. In 18 years, the child’s account will see many stock market corrections, booms and busts. I am not so concerned about a dip in the stock market with a child that young. I more concerned about the skyrocketing cost of college, otherwise known as inflation.
The real risk is inflation
Forbes recently reported the cost of attending college rose more than twice as fast as inflation. More than twice as fast as inflation. Costs rose 497% from 1985 to 2018. Good luck beating that inflation rate with low-yielding bonds.
Inflation is the real risk to a newborn, not a stock market correction when the child is 5 years old. Not only that, but if interest rates rise, bond prices may fall, making bonds by some measures riskier than stocks.
A better way
My advice: Forget age-based 529 options and pick the funds yourself, based on your time horizon of needing the money for college. Children more than five to seven years away from college may want to consider an all-equity portfolio to maximize growth. Given the high cost of college, you will need all the growth you can muster from your investments.
If you still want some fixed income in your 529 plan, you should ask yourself: What is the best approach? Does a bond index make sense? Probably not in this low-rate environment. A bond index owns short- and long-term bonds. Long-term bonds have more interest rate sensitivity, meaning if rates rise, your principal will likely go down. You should check whether your 529 plan offers an active fixed income manager to provide some investment flexibility. An active fixed-income manager may have charge more than an index but can better manage the fund for yield and adjust the holdings if interest rates do rise. Some 529 accounts offer a “stable-value” option, which may be lower yielding, but has better principal protection than a bond fund.
Start with reviewing the 529 plan of your home state versus an out-of-state 529. Does your state offer a tax-break for contributions to their 529 plan? Even so, how do the charges compare with your resident state’s 529 versus another state’s plan? You can use a 529 plan in other states. Some states, including California and New Jersey, offer no state tax break for contributions. Either way, you should compare the charges and mutual fund options in your state’s plan versus an out-of-state 529. Just because a state offers a state tax deduction for your contributions doesn’t make it a “good plan.” Besides, the state tax deduction doesn’t usually amount to much either. Other states’ 529 plans may offer lower charges or better mutual fund selection.
When it comes to picking a 529 plan and choosing the right mix of investments, parents can use discretion. A little effort today in choosing the right 529 plan or managing the investment choices can pay bigger dividends for your child in the future.