Consider 529 Plans for College Savings

Investigate the pros and cons of 529 plans; they can be attractive investments.

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Is there anything you can do as a parent if you want to help your children graduate from college without a huge debt burden? Yes—with a bit of planning.

One option is a 529 plan (named for Section 529 of the Internal Revenue Code that authorized them) which provides tax benefits in order to encourage saving for future college costs. They are sponsored by states, state agencies, and educational institutions and come in two types: prepaid tuition plans and college savings plans.

A prepaid tuition plan allows you to purchase credits at participating colleges and universities at current tuition prices. The credits, which can sometimes also be applied to room and board, are guaranteed to increase in value at the same rate as college tuition, effectively locking in the current tuition rate. Thus a year's worth of tuition bought at current prices will always be worth the same amount even if tuition has doubled by the time it is used. Prepaid tuition plans are sponsored by state governments and often have residency requirements to enroll. Many state governments guarantee the investments.

[Read about 4 ways to get out of paying tuition increases.]

If you choose a college savings plan, you establish an account and choose among investment options. The investment options include stock mutual funds, bond mutual funds, and money market funds, and age-based portfolios that automatically become more conservative as the beneficiary gets closer to college age. Mutual fund investments are not guaranteed by state governments and are not federally insured.

If you want to find and compare both types of 529 plans and see what your state (and other states) offer, savingforcollege.com is a great resource.

The tax benefits offered by 529 plans make them very attractive investments. First, you won't be subject to federal taxation. However, if you withdraw money from a 529 plan and do not use it on an eligible college expense, you generally will be subject to income tax and an additional 10 percent federal tax penalty.

[Learn more about saving for college.]

In addition, many states also provide tax advantages—such as allowing you to deduct contributions to a 529 plan from your state income tax returns—and benefits like matching grants. You will probably only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence.

As with any investment, it is important to understand the fees and expenses associated with 529 plans because they lower your returns. And, of course, if you aren't investing in a prepaid tuition plan that guarantees your investments, there is a real chance your investment may make no profit or even decline in value.

Jason Zweig, a columnist for the Wall Street Journal, noted recently that 93 percent of the 3,506 college plans tracked by Morningstar fell in value over the past year and 1,098 lost at least 40 percent of their value. A steep decline like this—the stock market was down 43 percent over the same period—can be devastating if it occurs during the period when a plan's earnings have to be spent.

As I mentioned earlier, some 529 plans have age-based portfolios designed to protect investors. According to Zweig, the way it should work is that an "account starts out primarily in stocks; with each passing year, more money moves into bonds and cash. By the time the student hits college, less than 20% of the money should be at risk in stocks—limiting the potential damage from even an epic bear market to 10% or so." Zweig contends, however, that many 529 plans failed to properly change their allocations from stocks to bonds and cash, took too much risk all the way along or made bad investment decisions.

The upshot: a 529 plan can be a great deal because of the tax benefits, but make sure you actively track the portfolio on the plan's website, at www.savingforcollege.com, or by calling the fund. And don't be afraid to demand changes if you don't like what you see. After all, it is your child's future that is at risk.

Isaac Bowers is the senior program manager for Educational Debt Relief and Outreach at Equal Justice Works. He was previously an attorney at Shute, Mihaly & Weinberger LLP in San Francisco, where he focused on environmental, land use, and planning issues. A graduate of the New York University School of Law, Bowers also has extensive experience in nonprofit advocacy and outreach.