Money Milestones: Downsides of a 529 college savings plan

Is handcuffing parents while they save for the children's college education a good thing?

By Bill DeShurko

Jun 3, 2015 @ 3:12 pm EST

By now you've probably been pitched a 529 College Savings Plan by your financial adviser, or discovered them on your own on the internet. Investment companies and state governments devised 529 plans with tax breaks to help relieve parents' financial burden by offering a tax free investment vehicle. In addition, 529 plans offer beneficial gifting opportunities, estate tax advantages and still allow the gift or to retain control. The trouble is few financial planners and state investment websites warn parents about the pitfalls of these college savings plans. After all they are first and foremost investment accounts. Here are four things you should consider before you buy a 529 plan:

1. You can make only one investment change per year in a 529 plan. While many investors will consider a 529 plan as a long term investment, there are many reasons that you may want to change your investment strategy. Market changes just being one. Also consider that transferring from one 529 plan to another is considered your investment change for the year. Handcuffing parents as they save for their kids' education cannot be a good thing.

2. To get the tax break in 529 plans, you must use that money for college expenses. Many states offer residents an income tax deduction when they purchase that state's 529 plan. However, that deduction is lost if the money is withdrawn for non-educational purposes, such as tuition, room and board, books and computer expenses, including equipment and Internet access. In addition your tax free earnings become taxable with an additional 10% penalty if not used for qualifying education purposes. While it may be a long shot, kids do get scholarships, and not just for sports. As Mr. Nelson found out, the trick is to find a school that really wants you.

3. Most states have one mutual fund company providing the investment choices in your 529 plan. When one company is providing all the funds in a 529 plan, your choices are limited. What's worse, those choices may be too conservative for your goals. Many funds within these plans tend to be more conservative due to their buy and hold limitations. However, don't confuse conservative strategy with low risk. The Vanguard 529 Moderate Growth Portfolio is described as a 50/50 mix of stocks and bonds. Sounds pretty conservative, right? But according to their website, the fund sports a Beta of 1.00 over the past three years. In English, that means the fund, despite being only about 50% in stocks exhibits the same amount of volatility as the stock market as a whole. Which sounds like twice the risk I'd expect from a 50/50 mix balanced fund.

4. You may just want to pay for college from current cash flow. You never know what the future may hold, but if all goes well your income could be considerably more than it is today. By your late 40'or even early 50's you may have maxed out your qualified plan options. Why shovel money into one investment, just to take it out of another for tuition?

So what is an alternative? Why not focus on a simple portfolio of individual stocks? The trick here is to not try and out think yourself. Just ask yourself a simple question: What companies are most likely to be around when junior trots off to college? Stick with Dow companies that pay a nice dividend, diversify among four to five industries and you are likely to do very well. Advantages: You can buy and sell at any time, stocks grow tax deferred and gains can be avoided if gifted and sold by your student that has little or no other income, and any dividends are taxed at lower rates. The biggest advantage is that stocks can be used for anything, at any time. If the portfolio grows enough, college funding could be supplemented just from dividends and interest preserving capital for the next student, or your retirement home.

Bill DeShurko is manager of the dividend and income plus portfolio on Covestor, the online investing marketplace, and founder of 401 Advisor.

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