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LOS
ANGELES - 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, Calif., 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 percent in 2008, forcing the
Nitschkes to borrow heavily to send their two sons to
the University of California-Los Angeles.
“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.”
In the
past 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 upfront
tax deductions for 529 contributions
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.
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 past
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.
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 percent from 1979 to 1997, but it
advanced only 14 percent 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.
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.
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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 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.
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.
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.
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