A 529 plan is still a good idea

by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation
April 23, 2009

Dear Carrie,
The downward slide of the market has made me wonder if it’s wise to open 529 accounts for my kids? Perhaps it would be better to keep the money in cash or invest in Treasuries instead?
—A Reader

Dear Reader,
I’m not surprised to get this question—and I’m certainly not surprised that many people are reluctant to put new money into the financial markets during this particularly disastrous stretch. No one knows with any certainty what the markets are going to do tomorrow, or next week, or next quarter, or next year. But I also believe that what’s going on in the markets today doesn’t change the utility or the power of 529 accounts for most investors. These college savings accounts were a good idea when the markets were solidly bullish, and they remain a good idea today.

529s: The basics
First, realize that 529s are simply tax-advantaged accounts designed to encourage people to save for a child’s college education. Each 529 plan is as risky as the securities contained in its portfolio, as I’ll discuss in more detail below.

By way of background: 529 plans come in two flavors: prepaid and savings. Prepaid plans allow you to pay future tuition at today’s prices, which might not be bad given that higher education costs generally outpace inflation. Nonetheless, they’re difficult to recommend. Most prepaid plans lock you into your state’s public system of higher education (or even into a specific college), and they generally don’t cover ancillary expenses. Savings plans are much more flexible: You choose how to invest the funds from a small spectrum of investment opportunities, and you can use the proceeds for qualified higher education expenses at any accredited college or university.

What makes 529 plans powerful—and more attractive than keeping the money in your name or opening a custodial account for your children—is that investment income grows tax free and can be withdrawn tax free if used for qualified educational expenses (which include the normal things: tuition, room and board, books and supplies, computers and Internet access, etc.). That’s worth a lot, but here’s another benefit: 529 plan assets are considered assets of the parents, not the child, which can make them better in terms of financial aid eligibility. (Assets of the child—like a custodial account—are counted more heavily when aid decisions are being made.) Moreover, parents can put quite a lot of money into 529 accounts without triggering gift taxes: up to $60,000 over five years and up to $300,000 in total in some states. The 529 assets can be transferred to other children or relatives without penalty. And they’re not just for parents; anyone can open a 529 plan for a child.

Your investment choices
So I think a strong case can be made for using the 529 plans as a tool to help you save for your children’s college educations. The real question you’re asking about, it seems to me, is what to invest in, particularly at a time when the financial markets are in the tank. But the near-term market slide is only relevant if your time horizon is near-term. If your child was going to college this September, you probably wouldn’t bother opening a 529 plan. Or if your child is due to begin college in the next few years, you would rightly choose conservative investments. But if your child is two years old with 16 years before she or he likely matriculates, then you will likely be willing to take on more risk in order to achieve a higher return.

Final thoughts
All 529 plans are offered by individual states, and they are available either directly from the state or through major brokerage firms. And while many plans do allow out-of-state investors, you should check to see if you can get a state tax deduction by going with your own state’s plan. If not, make your decision based on the costs of the funds themselves and the types of investment offerings available. All 529 plans are not created equal.

I know it’s hard to contemplate investing after recent declines in the stock market. But don’t let the recent past cloud your long-term thinking. As you should with any financial objective, look at your timeframe and look at the ways you can get the most out of your savings. I would suggest 529 plans as a great way to save for college, particularly if your children are young. Whether you take a conservative, moderate or aggressive approach, in the final analysis you have to ask yourself this question: Are you going to save and invest for your child’s education? If the answer is yes, then why not do it in a tax-advantaged way possible? A 529 plan makes that possible. In any event, good luck!