If you have kids, the thing you worry about most is how you will pay for their college education. Investment companies and state governments devised a product called 529 plans with tax breaks to help relieve parents' angst about how they're going to pay for it. The trouble is, investment firms and states don't warn parents about the pitfalls of these college savings plans. Here are five things you should consider before you buy a 529 plan:
1. You can make only one investment change per year in a 529 plan. When the stock market hit a low in March 2009, many investors panicked and pulled money out of the market—and may have fled their 529 plans, too. Many investors who changed investments in their 529 plans in early 2009 did not know that the IRS made a one-time exemption that allowed them to make two changes in 2009. (But who knows if the IRS will ever make such an exemption again.) As it stands now, 529 investors have one shot to make changes, but 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. Earnings in the plan are also not subject to federal taxes. However, it's difficult to forecast what path your child will take. Say your kid is gifted academically or is a sports star and earns a scholarship to college. Or say Sonny is a slacker and decides he doesn't want to go to college. So you don't need the 529 plan money to pay for college. Maybe you or your child want to use that money to buy a home. If you take money out of a 529 plan and don't use it for college expenses (tuition, room and board, books, and computer expenses, including equipment and Internet access), you won't get the state income tax deduction, plus you'll have to pay an additional 10 percent federal tax penalty on earnings.
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 because state treasurers, who are elected officials responsible for overseeing 529 plans, usually want to get reelected. If their plan performs poorly, their political career might suffer too.
4. You can get better returns if you invest on your own. I have set up taxable accounts for my kids so that they can use the money for their education, as well as any other large purchase such as a home or starting a business. I prefer to have an unlimited number of investment choices and be able to change funds whenever I want. For me, the flexibility and potential for higher returns in a taxable account outweighs the tax savings you get from a 529 plan.
5. States and investment companies get extra fees for selling 529 plans. When you purchase a 529 plan, you may have to pay enrollment fees, annual maintenance fees, and asset management fees. If you buy a 529 plan from a broker or adviser, you'll pay more in fees—sales charges can range from 1 percent to 5.75 percent of your contributions, according to Savingforcollege.com. You can save money by researching various state plans and buying a plan directly. When you're searching for a 529 plan, look at the annual average return for the funds in the plan after expenses (including management and state fees, and commissions). Also make sure to check each plan's fees for the different fund offerings because the costs can vary. The good news is that many states have lowered asset-based fees this year. It's very important to pay attention to fees because, in the end, these costs cut into how much money you'll accumulate to pay for your kids' college education.
There's one last, but very important, thing to remember: Saving for retirement should come first—before you start putting any money away for your children's education. Scholarships, grants, and student loans are readily available to help pay for college. But there are no scholarships for retirement.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April, 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store system.