Do 529 Plans Make Sense When Parents Get a Late Start Saving for College?
You're the parent of a teenager who is rapidly approaching college age. Like many Americans, you didn't save enough when your child was younger, and you're looking at a looming six-figure bill for tuition, room and board.
Should you try to invest as aggressively as you can or protect whatever nest egg you have?
In general, stock portfolios are more likely to deliver higher returns over time, but they also tend to have greater risk than portfolios containing bonds or a mix of stocks and bonds.
An investor with a longer time horizon can take on more risk than one who needs the money in a relatively short time. A 529 savings plan for an infant or toddler can take on more risk, because there is time to ride out market fluctuations.
When a family with a teenager is just starting to save for college, the first step is to evaluate risk tolerance, says Kathryn Spica, a mutual fund analyst at Morningstar. She suggests families look beyond the investment choices within 529 plans and consider all the funding sources available to them.
"There are a lot of nuances that come with planning for college that affect an investor's risk tolerance. Are they able to take assets from somewhere else, are they eligible for financial aid, are they willing to take out loans? All that really has an impact on the total portfolio, if you will, for college," Spica says.
To help mitigate market risk, many families turn to age-based 529 plans. These plans start out with a heavier allocation in equities and become more conservative as the beneficiary nears college age. By the time the student is entering college, some age-based plans have no equity exposure whatsoever and contain only bonds and cash.
For families getting a late start, it's important to consider asset protection, says Andrea Feirstein, founder and managing director of New York-based AKF Consulting. Her firm advises states, other public entities and plan distributors on the nuances and regulatory requirements of running 529 plans.
"If you want to look at an age-based option, understand what the asset allocation is in the age group your child is in right now and how quickly they'll move to the next age band," Feirstein says.
For example, while some plans have age brackets for beneficiaries between ages 13 and 15, others have the same allocation for teens between 13 ad 17. Some families may be comfortable with a more aggressive allocation for that longer time period, but others may want to decrease their equity exposure when their child is age 15 or 16.
In addition, Feirstein emphasizes that many states offer different age-based allocations, even within the same age brackets. "This is a development we've seen over the last eight or nine years," she says. "It used to be that there was just one age-based option, and the asset allocation was what it was. But as plan managers become more sophisticated, we now have plans with a conservative option, an aggressive option, and in many cases, a moderate option."
Plenty of families who haven't saved enough hope to play catch-up as their child approaches college. However, by investing too aggressively and taking too much equity risk, you can put your nest egg in peril, says Richard Feigenbaum, partner at law firm Feigenbaum & Uddo in Wellesley, Massachusetts, whose practice includes estate planning. Feigenbaum is co-author of "The 529 College Savings Plan Made Simple."
It's important that late starters be realistic in their expectations, he notes. "If you're counting on a lucky tailwind market to raise your portfolio by 25 percent in three years, perhaps you're taking too much risk, and that's not appropriate," he says.
Because parents and grandparents of teens have a short time period in which to save for college, market timing mistakes can be especially hazardous, Feigenbaum points out.
At the other end of the spectrum are those who are extremely risk-averse. For those savers, most plans offer a money market option within a 529 savings program. Those accounts are the least risky, but they won't keep pace with inflation. However, they may offer peace of mind for investors who simply can't stomach a market roller coaster.
Morningstar's data show that the 529 plan industry average for equity exposure ranges from 10 percent to 15 percent for teens approaching college. Spica says investors should understand the construction of a plan's allocations before they invest, with an eye toward the increased market risk that comes with stock investing.
"You have to ask, 'What am I most concerned about?' Are you concerned about any type of investment drop, whether it be stock market or bond market? Do you want to be all in cash, or do you want to avoid equities altogether because there's risk there?" Spica asks.
Sometimes seeking professional advice can give investors a better picture of their actual risk tolerance. Risk profile questionnaires and an analysis of a family's overall situation can lead to a more scientifically based allocation, rather than a guess or an emotional decision.
"Groups of people who have a financial advisor can attack the problem differently from groups of people who don't," Feigenbaum says. "They have access to information and know-how."
Feirstein says professional guidance is worth the cost in many cases. Although direct-sold plans generally carry fewer fees, the right strategy could more than make up for what a financial advisor would charge.
"If you are a parent who is in a quandary, if you are not confident about the choice you are making and you really are worried about getting the most you can out of the next four or five years, that may be the time when you want to work with a financial planner or advisor to avoid a mistake," she says.
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