Parents of future college students shouldn't pick a 529 plan, a tax-advantaged investment account – or the individual investments within a plan – blindly. Instead, they should look for signs the plan will grow enough to pay for their children's education.
529 plans contain a variety of investments of the owners' choosing. Each plan has a set of investment options ranging from savings accounts to mutual funds. There are also package options such as age-based plans where a selection of investments adjusts automatically on a regular basis to lean toward safer investments as the child ages.
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The most important sign to look for is an investment's historic growth rate. While plans and individual investments within plans that have made money annually may not do so in the future, parents have to go by something when making their choices, says Clare Levison, a Virginia-based certified public accountant.
Experts say there are several things parents should know about how to use an investment's past performance to gauge its potential.
1. Don't compare this year's earnings with last year's: The stock market has good and bad years. If the stock-based mutual funds in a parent's 529 plan didn't do as well as last year, compare those growth rates with general indexes such as the Standard & Poor's 500 index or the Dow Jones industrial average, Levison says.
These indexes are comprised of stocks that are supposed to give a good indication of how the stock market performed as a whole. Parents should look at their 529 plan indexes to see how their own investments did.
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Most financial and investment websites will chart trading performance and offer users the option to update the time period the chart displays. Parents should check the performances of an index and their own mutual funds over a one-year time period.
Typically, sites will also display a percentage that represents total growth. In the case of the S&P 500, that was nearly 20 percent over the last year.
For age-based 529 plans, Chadderdon W. O'Brien, a New Jersey-based financial planner and risk manager with Lassus Wherley, says it's more important that parents look at how 529 plans performed in a year compared with other 529 plans rather than simply looking at an increase in value.
Each age-based plan has goals set to achieve long-term results for the parent. For instance, 529 plans that performed well for young children in 2008 that were supposed to be invested aggressively likely were invested in long-term bonds, he says. Even if that strategy resulted in greater earnings that year, cash and bonds generally have lower earnings than stock market investments, he says.
2. Consider the long term: Experts also advise parents to look at long-term results. "When looking at past performance, I tend to consider the 10-year returns, maybe the past five," says Jason Washo, an Arizona-based certified public accountant and personal financial specialist.
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Sites typically allow users to view a fund's performance over five- and 10-year time periods, both as a chart and as a percentage. To see a specific mutual fund, parents can search for the name or stock ticker symbol the same way they looked up the S&P 500.
3. Contemplate risk tolerance: Risk tolerance – how much money a parent is willing to lose – is the biggest factor in determining what investments to choose, Levison says. A mutual fund that's meant to be riskier could have great returns one year and not the next.
The question is whether parents who enjoy a 25 percent return are okay if it drops 25 percent the next year, she says. That's why diversity of risk is important.
Parents should balance their investment choices within their 529 plan accounts based on different levels of risk and the reward of higher returns. Doing so will help them to achieve their savings goals in the amount of time before their children enter college, Washo says. That could mean choosing riskier investments with greater growth potential like stock market-based equity funds.