Choice is a Good Thing, Right?

March 22, 2012

In the 1970s, I lived in England before Margaret Thatcher came to power. In those days there wasn’t a lot of choice for consumers at the supermarkets: three types of cereal – Wheetabix, cornflakes or oatmeal – and two kinds of instant coffee.  When I first returned to the U.S., I spent hours in the grocery store marveling that there was a whole aisle for cereals and another for cookies. And olives!  Six different varieties, based just on the olive’s size.

But too many options – with a lot riding on the decision – and marvel turns to muddle.  Such is the case with choosing a college savings plan – an investment which many American parents consider as important as their homes or 401(k)s.

Fifteen years ago we were still in the cornflakes era for college savings. There were custodial accounts, education trusts or saving in your own accounts.  Choosing among these options depended primarily on how much control parents wished to retain and different applicable tax rates.  If you had reason to believe your son was just as likely to join the circus as go to college when he turned 18, you went the trust route or just saved in your own name.  Otherwise custodial accounts worked just fine.

Congressional action in 1996 brought tax-advantaged 529 plans to the marketplace.  These plans are run by the states and the District of Columbia, creating at least 51 programs.  To add to this embarrassment of riches, there are basically two types of 529 plans: 1) prepaid plans where contributors pay for tuition at a state school in advance, thereby hedging against unexpected inflation of college fees and 2) savings plans.  In this latter case, the contributor creates an investment account and retains the risk of college cost increases for the opportunity to earn higher, tax-exempt investment returns.

The state-branded plans are distinguished, in turn, by different investment managers and investment options, different rules for whether out-of-state students or relatives can purchase into the plan, different state tax benefits, different provisions for refunds if the student does not go to a school in the state offering the plan, different levels of guarantees for the prepaid plan, and different expenses.  If that were not enough, there are now college-sponsored 529 plans and plans offered by consortiums of private colleges for those students interested in attending one of these colleges.

Still with me?  Or are you lost in Alaska’s program or perhaps Tennessee’s?

If ever there were a need for shortcuts, it’s here in the jungle of 529 plans. So following are my shortcuts in the form of some “DO’S” and “DON’TS.”  While they won’t necessarily lead you immediately to the one perfect savings plan for you or your child, they will help you hack a relatively straight line through the overgrowth of features, options and requirements, to get you to a manageable number of plans to consider.

DON’T wait until it’s too late to set up a 529 plan.

Most prepaid plans impose an age-limit that excludes children already in high school.  With a savings plan, you may lose most of the benefits of tax-free compounding to the upfront costs of establishing and maintaining the plan if the holding period is too short.  If the child has started to surf college websites, then you can set aside funds in your own name, invested in low risk holdings.  If your marginal tax rate is high, good quality municipal bonds are suitable; if not, look to bank CDs.

DO consider a pre-paid plan but DON’T limit yourself to your own state.

First of all, many states have eliminated this option, due to concerns about whether they can meet the obligation to cover future tuition costs. Currently, there are only a handful of programs to consider.  Check for your eligibility to purchase.  Most require that the student, the owner (funder) of the plan, or the parent be a state resident.  Two programs – specifically Massachusetts and the Private College 529 plan– are open to all comers.

Even if your child is not likely to attend college in a particular state, the state’s prepaid plan can be used in your overall 529 investment allocation as a safe or low-risk option.  Most prepaid plans do allow a return of your money if your child chooses to go to an out-of-state college; many give back a current tuition-equivalent amount or a market rate of return on your funds.  So rather than investing all your money in a savings plan and apportioning some to short-term bonds or cash equivalents within that savings plan, use a prepaid plan for this share and use the savings plan for higher risk, higher returning investments.

DO think twice before automatically opting for a savings plan with an age-weighted option.

These plans put you on an automatic investment “glide path,” adjusting your equity/fixed income allocation according to your child’s age.  Some of these plans have been criticized for being too aggressive in the early years, resulting in losses of 25 percent or more in the recent market meltdown. However, my concern with age-weighted plans pertains to their heavy bond allocation as your child approaches college-age.  Bond market crashes DO happen, as some might remember from 1994. And because interest rates cannot go much lower than they are today, depreciation of bond prices going forward seems more likely than not.  The point is that age-weighted plans do not eliminate the need for monitoring and re-balancing the portfolio to adjust to current circumstances.

DO pay attention to 529 plan fees, and stick to lower-fee options.

Remember that every dollar in fees is a dollar not compounding tax-free.  If you are contributing a relatively small amount to the plan, pay particular attention to fixed dollar fees since they have a bigger negative impact on the investment performance than if you contributed more. Be aware that there are three types of fees: application and service fees, state management and investment management fees, and in some case, fees paid to a broker, if the plan is a “broker-sold” plan.

Finally, DON’T be daunted when it comes to finding the right plan. 

Help is available.  Competent advice from a CFP® professional and/or broker specializing in these plans can help you make a good choice and avoid costly mistakes.  There is also an excellent website www.savingforcollege.com for learning about the various features of 529 plans and screening them based on the characteristics most important to you.

Getting a 529 plan is not dissimilar to ordering a Starbucks coffee.  In one case, you need to specify the number of espresso shots, frappuccino or cappuccino or latte, foam or no foam, skinny or whole, and whipped cream with or without drizzle.  In the other, it’s prepaid versus savings, in-state versus out-of-state, broker-sold versus direct-sold, et al.   Yet when all is said and done, both Starbucks and 529s are definitely good things, especially for sleep-deprived new parents.