The Great College Savings Fiasco

This article was originally published by on Thursday, Jan. 15, 2009.

529 plans, sold for a decade as the 1-stop solution to paying for college, haven't performed as advertised. And for many families, there's a better option available.

By Katherine Reynolds Lewis

Mention "college savings" to a financial professional and you'll likely be steered to a 529 plan.

In the decade since these investment accounts were created, they've become practically synonymous with college savings. and the College Savings Plan Network are exclusively focused on 529 plans, for instance.

But many parents who have invested in 529s, counting on the market to help cover the soaring costs of college, would've been better off putting the money under their mattresses.

The plummeting stock market has erased many if not most gains. The balance could be less than the parents have contributed. And parents of older children, in particular, don't have much time to make up losses before they need to pay tuition.

Margot Black, a Los Angeles writer and publicist, put $15,000 into a 529 plan for her toddler son, only to see the account lose 40% of its value in less than a year.

"It was heartbreaking to watch," Black said. "The 529 plan is sold to parents as the no-hassle investing fund. . . . I honestly thought we had done such a good job upfront that we could relax."

Simply put, 529 plans don't live up to the hype. Though they remain a good choice for some, you should understand the trade-offs and alternatives before putting your college fund into one of these heavily marketed plans.

"People like to think they have a college savings account that will solve their college goal," said Tim Higgins, the author of "Pay for College Without Sacrificing Your Retirement." "But a majority of the people investing in these should be looking at other avenues."

What is a 529?
A 529 plan provides tax-free growth on money you've put away for college or technical school. You sign up for a 529 account on behalf of a beneficiary, typically a child or grandchild. You contribute after-tax dollars, but you pay no federal taxes on withdrawals for qualified college expenses.

"There are very few opportunities the government gives us to earn money tax-free. This is one of those," said John Gugle, a certified financial planner in Charlotte, N.C.

The plans are administered by state agencies and often managed by the same mutual fund companies that invest 401(k) and similar retirement plans.

Each state determines how to structure its plan. Many offer a deduction from state income tax for annual contributions up to a specified amount.

If you opt for an out-of-state 529 plan, you forgo in-state benefits but still receive the federal tax exemption. (Several states also offer 529 prepaid tuition programs, which are different from the plans addressed in this article. In these, you pay for future tuition today, at today's prices.)

Unlike other college-savings accounts, which are legally the property of the child, 529 plans are controlled by the adult who opened the account. You may change the beneficiary to another family member.

They've become incredibly popular, with 11 million accounts nationwide, said Chris Hunter, a spokesman for the College Savings Plan Network. Every state (and Washington, D.C.) offers at least one 529 plan, for a total of 85 savings plans. Assets totaled $129 billion as of June 30, up from $15 billion in 2001, according to data from the savings network.

The problems with 529 plans
Sound good so far? Unfortunately, 529 plans are neither simple nor problem-free. Here are the biggest drawbacks.

-- Investors in 529 plans pay at least two layers of fees. The 529 administrator gets one fee, and the manager of each underlying mutual fund receives a second. If you purchase a 529 plan through a broker, you pay a third fee. Many plans also charge an annual fee of $20 or so. Those are hefty charges compared with, say, a no-load mutual fund.

-- 529 plans offer a limited range of choices. When you open an individual retirement account or a brokerage account, you can generally choose from a broad range of stock and bond funds, commodity investments, foreign currencies and bank products. Not so with 529 plans: You're limited to a few options the plan manager has chosen.

-- You can change investment choices only once a year. In most other investment accounts, you can make multiple changes in your portfolio during a year. 529 plans restrict your ability to respond to market changes by revamping your investments.

-- The options are often confusing. Of course, sometimes too much choice is difficult. Looking at the variety of 529 plans listed by and the College Savings Plan Network can make you dizzy. Parents who've made it through the lengthy decision-making process may be less than enthusiastic about revisiting their plan and its investment allocations on an annual basis, as many financial advisers recommend.

-- Colleges consider a 529 account a parental asset for purposes of financial aid. The money you save in a 529 plan counts against you when colleges calculate the family's expected financial contribution. "We have a family that needs financial aid but won't get it because they have a 529 plan," said Manuel Fabriquer, a college planner in San Jose, Calif.

-- You escape federal taxes only on the account's growth. That's great if your investments soar, but if they decline, you get no break at all. This last point is the key right now.

You may have learned about the benefits of tax-deferred growth when you opened a 401(k) plan at work. You contribute pretax dollars, and you pay taxes on your contributions and any investment growth when you make withdrawals years from now. A 529 plan works differently. You contribute after-tax dollars, and you're never taxed on withdrawals for college costs. The growth escapes federal taxation completely.

But parents with children close to college age should invest conservatively because they'll need the money soon. "Most people saving into these accounts don't have newborns. These are middle school, high school families, and they've got to be invested conservatively, so there's not going to be much growth," Higgins said.

And with the market flat or down, as it has been for more than a decade now, there's often no real tax benefit at all.

You should save for retirement first
So what's the right strategy?

College costs are climbing faster than the rate of inflation. Private colleges' tuition and fees have climbed at an average of 2.4% a year, after inflation, over the past decade. That figure is 4.2% annually for public institutions.

For the 2008-09 school year, on average, a private four-year college costs $34,132 for all charges, and a public four-year college costs $14,333 for state residents and $25,200 for out-of-state students, according to the College Board.

Parents feel responsible when they open a college savings account. But as financial planners say, nobody gives you a loan for retirement.

The responsible act as a parent is to make sure your own retirement accounts are fully funded, so your children won't have to support you in your old age.

"The first place people should save, no matter what, is in their 401(k) if they're getting a match. This is a no-brainer," Higgins said. "The majority of families are not maxing out their 401(k)s and Roth IRAs."

Unlike a 529 plan, a retirement account doesn't count as an asset when colleges calculate financial aid, so your student may be more likely to get help. And if you still need help funding college, you can often take out a loan based on the assets in retirement accounts.

A better alternative: A Roth IRA
In fact, a retirement account may be your best college saving option. A Roth IRA gives you most of the federal tax benefits of a 529 plan and none of the drawbacks. (You can open one if your family's 2008 adjusted gross income is less than $169,000, or $116,000 for a single taxpayer.)

"The No. 1 college savings vehicle is a Roth IRA," Higgins said. "Here's an account where, if you have kids in high school, you can invest in anything you want."

It's a retirement account, but after five years in a Roth IRA, you can withdraw your contributions penalty-free. You can withdraw both the contributions and earnings for higher education expenses without a penalty, though you do pay taxes on the growth (unless you've reached 59 1/2.)

And if your child doesn't end up going to college, you've got an extra cushion for retirement.

Some people should use a 529
To be sure, a 529 plan can be a terrific choice for some people. Well-off families that are on track for retirement and have reached the limits on other tax-deferred plans should consider one of the top 529 plans. But pay close attention to investment choices and fees.

"They're perfect for two (kinds of) people: those with time to grow it and for grandparents," Higgins said.

Take Paul Lightfoot, a father of two and the chief executive of Briarcliff Solutions Group, a New York software company. Lightfoot is sanguine about the roughly $4,000 that his 3-year old daughter's 529 plan lost last year because the account has 15 years to make up the losses.

"We know the world runs in cycles," he said. "We're going to put in money when times are good and when times are bad."

Think twice about stocks
Whether you choose a 529 plan or other vehicle for college savings, make sure you carefully consider when you'll need the money before blithely sinking it into stocks.

The lessons that many of us learned in saving for retirement about the power of tax-deferred compound growth don't translate perfectly to college.

"For a 401(k) or IRA, people are investing for a lifetime and then to live off that for 30 years. With a 529, generally folks are saving for 18 years or less to live off that money for four years," said Adam Miller, a financial planner in Montrose, Colo. "You have to be way more conservative. It's so much more squished. There's such a shorter time frame. You really have to manage that."

Indeed, Joseph Hurley, the founder of, stresses that how old your child is will greatly affect whether you want to invest any college savings in the stock market.

"If you need the money to pay next semester's bills, you might not want to be exposed to the stock market," Hurley said.

Katherine Reynolds Lewis has a 529 plan for each of her three children. All three plans have lost money.

Questions to ask before opening a 529 account:

Do I have enough time before my children are in college to expect serious growth in this account?

What are the fees and benefits associated with the state-run plan?

Are there out-of-state plans with better underlying performance and lower fees?

What are my options if my child doesn't go to college or I decide to close the account?


You might want to avoid a 529 plan if:

You qualify for a Roth individual retirement account.

You haven't fully funded your own retirement.

Your children are close to college age.

You are low- or middle-income and might qualify for financial aid.