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A New Twist on Using 529 Plans to Save for College
Last week I was quoted in an article in the Wall Street Journal regarding the use of the Private College 529 savings plan. In the article I described a strategy of segmenting the fixed income portion of college savings and targeting that in the 529 plan. I thought I would use this blog post to go into a bit more detail on this strategy.
As we have all heard now for years and years, the cost of a college education keeps on going up and often times at a rate greater than the general inflation rate. State sponsored 529 college savings plans provide parents with a way to invest money for their children's college expenses and not pay any taxes on the earnings if the funds are used for college. There are a myriad of plans out there and choosing one can certainly be confusing.
One aspect of many of these plans is the 'age-based' savings plan. With this type of investment the money you invest is slowly moved from risky equities to less risky bonds and cash as your child ages. For example, for a newborn some plans will invest 100% of the funds in equities and then slowly over the years reduce that percentage until it reaches 20% when the child is in college. (Each plan seems to have a slightly different mix of equities and fixed income at each age which is something to be cognizant of when investing in these plans.) The problem with this approach is that yields are incredibly low on fixed income right now. Cash is effectively paying 0% and even most bond funds cannot expect to yield more than 2%. So, if your child is in their pre-teen or early teens, about half of your money is already in these low-yielding asset classes. This makes sense given that your child will be in college in about five years or so, but if the equity markets have a bad turn over this time frame there is realistically no way to keep up with general inflation, not to mention college inflation.
Here is a potential way to hedge college inflation with the fixed income portion of your 529 savings: invest that portion in a Private College 529 plan. Now, if you are certain that none of your children would ever go to any one of the 270 schools that participate in this program, you can stop reading now. But, if you even think that at least one of your children could go to one of these schools, please read further. The main point of the Private College 529 plan is that you are purchasing tuition at today's prices. For example, if Princeton is charging $40,000 a year for tuition today and you invest $20,000 in the plan, you are buying 1/2 a year of a Princeton education for your child today. No matter how much prices go up between now and when your child enters college, you will have a guaranteed 1/2 a year at Princeton. (Getting the admissions department to invite your child is another matter of course!) If another college charges $50,000 a year then you would be buying 40% of one year at that college with your $20,000 investment.
I have been watching this plan and considering it for many years for my own children who are now ages 10 and 7. My objection at first was that I had no idea where my young children would go to college so how could I lock them into a particular group of schools. Well, now that they are a bit older, I am fairly confident that at least one, and probably both will end up at a private college. But will they choose one of those on this list? And will they be accepted?
After looking at the list of schools I thought that the chances of at least one of them going to one of the schools on this list was probably better than 50-50. If you have more than two children and think it is likely they will end up at private colleges, this makes all the more sense. If you only have one child, maybe less so. (But you should still consider this.)
So, at this point you have a perfect inflation hedge with the fixed income portion of your savings. I did exactly this last year with my children's 529 savings. I left the portion that was in equities in the same plan it has been invested for years. Instead of having the fixed income earn 2% (or less) over the next 7-10 years, I'm guaranteed that that portion of their savings will keep up with college inflation costs.
Next consideration: what if neither child goes to any of the 270 colleges that participate in this program? The plan which is managed by Oppenheimer guarantees a return between -2% and a +2%. Given where fixed income yields are today, I'm not expecting more than a +2% return anyway. If the equity markets tank in the next 7-10 years, along with the other portion of our 529 assets, then I'll feel pretty good about 'only' losing 2% on this portion of the assets.
Hence, in the end I view this a great way to hedge college inflation costs with minimal risks. While one theoretically has credit risk with Oppenheimer, the colleges themselves are the ones guaranteeing the tuition credits. The only other risk that was pointed out to me recently by one of my clients is the risk of college deflation in the next few years. While I personally think this is unlikely in the private college market in the next 5 years or so, there is certainly a trend towards free or low-cost online educational options that could drive down the costs of obtaining a degree in the future.
It was also pointed out that many students who attend elite colleges receive some type of scholarship or tuition discount. While that may be true, they only offer this based on need. The strategy I am advocating is based on how to utilize the funds one has already decided to set aside. Planning on a college to pick-up the tab for your child is not a plan, and not one I would advocate.
I hope you have found this post interesting. If you would like to ask me a question, please e-mail me at: ken 'at' weingartenassociates 'dot' com. Or you can call me at 609-620-1770.