How should you invest money in a 529 plan? These college savings plans present some unique investing challenges. On the one hand you want the money to grow to at least keep up with the rising cost of college. On the other hand, there is a limited time horizon. Assume too much risk and the stock market might wipe out much of your savings.
These challenges came to mind as a read this email from a reader named Robert:
Hi Rob. I have an idea for a future podcast or blog if this has not been previously covered. I have 529 plans for both of my children ages 12 and 15. Unlike retirement planning, college tuition planning has a predictable, somewhat fixed date for which you will need the money and typically need it for 4 or more years. Along these lines, asset allocation strategies are somewhat different and market timing may be appropriate since a bear market can wipe out your investments if you have too much risk on the table as your child approaches college age. I’m not sure if you’ve used 529 plans for your college tuition planning but it might be worthwhile for your readers/listeners to get your perspective.
FYI, my tenth-grade son currently has 30 percent equities, 36 percent bonds and 34 percent money-market in a Vanguard, state-sponsored plan. My seventh-grade daughter has 43 percent equities, 28 percent bonds and 29 percent money-market. In addition to time horizon, one’s 529 allocation may also depend on assets in the plan, ability to divert income or other savings to college tuition, expectation of financial aid or scholarship, family support, college choice (usually unknown until months before you need the money) and numerous other factors. Again, it might be an interesting issue to digest in a future program.
I just love the fact that Robert knows the asset allocation for each of his son and daughter’s 529 plans. Investing for college in a 529 plan is different than investing for retirement. As much as there are similarities, there are a couple of very significant differences. When you’re in your 20s or 30s or 40s and you’re saving for retirement, you have a much longer time horizon than you do with a 529 plan. Also, most college savings plans are exhausted in about four years; retirement should last for decades (hopefully!).
So how do you go about figuring out your asset allocation? In this article we’ll cover the basics of a 529 plan as well as explain how age-based portfolios work.
The 529 Plan Basics
A 529 plan is a tax-advantaged account that enables you to save for your child’s education. Actually, you can have a beneficiary of the 529 plan that is not your child. Although most people probably think of 529 plans for their kids, grandparents could save, too. There are federal and state tax advantages for these accounts.
Federal Tax Benefits
At the federal level, you don’t get a tax deduction for contributions to a 529 plan. You contribute after-tax dollars. The tax advantage is that gains in the account grow tax-free, assuming you use the money for qualified educational expenses.
For those that start investing when their child is young, these tax advantages are significant. There is no federal tax on the interest or dividends generated each year from the investments. And there is no tax on the capital gains when the investments are sold and used for qualified educational expenses.
State Tax Benefits
At the state level, you also get the tax advantages on the earnings from the investments. In some states, you also get a deduction for the contributions. Typically there is a limit to the deduction, which varies from state to state. At the end of this article you’ll find a Vanguard map that quickly and easily shows you the tax advantages offered by each state.
A 529 plan is similar to a 401k when it comes to investments. You are limited to the investments offered in the plan. As a result, you need to pick a plan based, in part, on the investments offered. In this sense, evaluating the investments is no different than evaluating a mutual fund for retirement investing.
As you’re shopping around for 529 plans, you’ll want to look at the investments they offer as well as the tax advantages. If your state offers a deduction for contributions, you’ll of course want to consider this factor as well. While you do not need to use the 529 plan in your state, you won’t get a deduction for the contributions if you use a plan in another state.
In terms of investing, one of the easiest approaches is to use age-based portfolios, which many of the 529 plans offer.
Age-based portfolios make investing for college extremely easy. These portfolios include a mix of stock and bond funds with the asset allocation based on your child’s age. As your child gets closer to college, the investments become more conservative by shifting more of the assets out of equities and into fixed income investments. The change in asset allocation is automatic as your child gets older. Here are the details.
When your child is younger and you have a longer time horizon for investing, these portfolios invest heavily in stocks. While the specifics vary from one state to the next, in Virginia the mix at this stage is 80% stocks and 20% bonds. Here are the details (note that Virginia calls this portfolio the Rappahannock. There’s nothing significant to the name, other than they like to name their portfolios after rivers and landmarks in Virginia):
As your child ages and gets closer and closer to needing the money for college, age-based portfolios will automatically shift the investments to a more conservative allocation. With the Virginia 529 plan, for example, there are a total of seven asset allocations ranging from 80% stocks and 20% bonds (the Rappahannock portfolio above) to 100% fixed income as your child enters college. Again, these changes in the allocation occur automatically as your child ages.
Does this work the same for retirement savings?
I should add that the changes in asset allocation for a 529 plan have no application to retirement investing. When you hit retirement at say age 65, a 100% bond portfolio would expose most people to longevity risk (the risk of outliving your investments). For a college education, you’re generally looking at a 4-year time period in which to spend the money. When you retire at age 65, you’re looking at a 30-year time period for retirement. Because retirement spans a much longer time period than does college, the investing horizon is much different. Not only do you still have time to handle market fluctuations, but you have to account for inflation over a much longer time period.
Another Alternative to Age-Based Portfolios
If you don’t have age-based portfolios, what should you do? In the case of Virginia, they have non-evolving portfolios, meaning the investments do not get reallocated as your child gets older. You can construct your own portfolio with these investment options, but you’ll need to change the allocation as your child nears college. You can, however, use the age-based portfolios as a good to a reasonable asset allocation.
There are a number of very good online resources for 529 Plans. One resource that can quickly and easily tell you whether a state offers tax breaks on a 529 Plan is a clickable map offered by Vanguard. The map also tells you if a 529 Plan is managed by or at least offers Vanguard funds: