College Saving Gets Trickier
Burned by your 529 plan? There's a chance that your provider has sweetened the
deal. But recent tax changes may make other strategies more attractive.
By JANE J. KIM
Families need to know which college-savings vehicles make sense right now -and which don't.
After being pilloried by critics and written off by many families, 529 collegesaving plans are getting better. But well-heeled investors still would be wise to
spread their bets around.
So-called 529 plans allow people to save for college expenses and withdraw the
earnings tax-free. Many also offer a break on state income tax—savings that, in
theory, an investor can roll back into the account.
For years 529s were pitched as the ultimate college-savings vehicle, but their limitations were thrown into sharp
relief during the financial crisis. Too reliant on stocks, the average 529 investment option lost nearly 24% in 2008.
Even portfolios geared to older kids just a few years away from college got hammered, losing 14%, according to
investment-research firm Morningstar Inc. What's more, because savers can generally make investment changes
only once a year, many people watched helplessly as their accounts dropped in value.
From safer 529s to retirement plans, WSJ's Jane Kim and SmartMoney's AnnaMaria Andriotis discuss which
college-savings vehicles make sense right now--and which don't.
The plans have other well-known shortcomings. Many states, for example, charge additional plan-management fees,
so the average fees tend to be higher than their mutual-fund counterparts, according to Morningstar, which recently
started rating 529 plans (available at www.morningstar.com/goto/529map).
Performance, meanwhile, has been a mixed bag: According to Morningstar, 529 plans lagged their retail mutualfund counterparts in four out of seven fund categories on an annualized basis over the five-year period ended
October. And most of the plans still offer limited investment options or investments run only by the program
manager—though more states are adding third-party options.
The problems prompted some families to pull back. In 2010, for the first time, they took out more money than they
added in any one quarter—$113 million in net outflows in the three months ended Sept. 30, according to the College
Savings Foundation, an industry group. The foundation says the distributions reflect the fact that more families now
are tapping the plans to pay for college.
The industry is addressing the criticisms by dropping fees, rethinking asset allocations and adding more options,
such as low-cost index funds and bank products, including certificates of deposit and savings accounts. Last month,
for example, First National of Nebraska's First National Bank of Omaha took over three of Nebraska's 529 plans
from Union Bank & Trust Co., and promptly lowered the program manager's fee to 0.26% from 0.6%, expanded
outside investment options and made the portfolios more conservative.
Other providers cut fees or added new products last year. In September, Fidelity Investments added "bank-deposit
portfolios"—FDIC-insured interest-bearing bank accounts—across five of its 529 savings plans. Last fall, Vanguard
Group reduced fees across the plans it manages in Nevada, New York, Iowa and Missouri. In July, T. Rowe Price
Group Inc. cut the plan-management and account fees in its Alaska and Maryland 529 plans.
Among the plans that earned Morningstar's top ratings: the Alaska and Maryland plans run by T. Rowe Price,
Nevada's Vanguard 529 College Savings Plan, Ohio's CollegeAdvantage 529 Savings Plan and Virginia's broker-
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sold CollegeAmerica plan. Plans that got below-average marks include Georgia's Path2College 529 Plan, Nevada's
Upromise College Fund 529 Plan and Wisconsin's Tomorrow's Scholar College Savings Plan. Rhode Island's
CollegeBoundfund was the only plan to get Morningstar's lowest rating.
Even though 529 plans are making strides in addressing their flaws, families should consider spreading their bets,
both in other investment vehicles and in different assets classes, say advisers. That will help them reduce the risk of
relying too heavily on any one investment, and will build in more flexibility in case the money is needed for other
purposes.
The good news: Thanks in part to the recent tax-rate extensions, there are plenty of other college-savings options
worth considering, from standard brokerage and custodial accounts to Coverdell Education Savings Accounts and
even Roth individual retirement accounts. The proper mix depends on individual circumstances, of course.
Where to Save
Wary of market volatility and in search of more flexibility, more families and advisers are expanding their collegesavings repertoire. Here are some options to consider:
529 Savings Plans
Qualified distributions are taxfree, and many states offer tax deductions or credits for contributions.
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Pros: Can result in big tax savings for families able to sock away substantial sums.
Cons: Some plans may have limited investment choices and charge high fees, and savers can face taxes and
penalties if the funds are pulled out for other purposes.
Financial-Aid Impact: Minimal, if treated as parental asset.
529 Prepaid Plans
Families make an upfront payment in exchange for future tuition contracts or credits.
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Pros: Prepaid plans aim to cover tuition no matter how much it increases.
Cons: Some states, facing budget woes and rising tuition, have had to close their plans to new participants,
raise prices or impose fees.
Financial-Aid Impact: Minimal, if treated as parental asset.
Coverdell Education Savings Accounts
Offer tax-free growth for education expenses.
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Pros: Cover a broad range of expenses, including college and K-12 expenses, while offering more
investment choices.
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Cons: Impose income restrictions and a low $2,000 contribution limit. Current tax benefits extended only
for two years.
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Financial-Aid Impact: Minimal, if treated as parental asset.
UGMA and UTMA Custodial Accounts
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Accounts in which the parent acts as trustee. Offer some tax benefits where the first $950 of investment income is
tax-free. Any income between $950 and $1,900 is taxed at the child's rate, and income above $1,900 is taxed at the
parents' rate.
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Pros: Can be used for most anything as long as the proceeds benefit the child.
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Cons: Students gain control of the accounts when they come of age.
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Financial-Aid Impact: Since the accounts are in the child's name, they are counted more heavily in
financial-aid formulas.
Taxable Brokerage Accounts
Families can save for college in a standard taxable portfolio.
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Pros: Investors have complete control over their investment decisions; accounts can be used for any
purpose.
Cons: Investors are likely to face a tax bill on growth and withdrawals.
Financial-Aid Impact: Federal aid formulas count the value of the assets in the account (minus any
margin loans) at the time the federal financial aid application is filled out.
Roth IRAs
Investors can generally withdraw their original contributions without taxes or penalties not only for college, but any
reason.
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Pros: Offers more flexibility and investment options.
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Cons: If the parent is relying on the account for retirement, any withdrawals will chip away at the nest egg.
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Financial-Aid Impact: Assets aren't counted in aid formulas, although withdrawals of a contribution are
treated as income under aid formulas.
Savings Bonds
Interest earned on the Series EE or I bonds is free from taxes if used for qualified higher-education expenses.
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Pros: Among the safest investments.
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Cons: Currently, bonds pay a relatively low rate of return while the tax break is limited.
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Financial-Aid Impact: Income from the bonds is considered income under aid formulas.
Sources: WSJ Research; FinAid.org
Here are some options to choose from:
• Coverdell accounts. The extension of the Bush-era tax rates maintains investors' ability to contribute up to $2,000 a
year into these accounts. With Coverdells, investors can make tax-free withdrawals to pay for a broad range of
educational expenses, from tuition for private elementary school and college to tutoring and computers. Investors
can open them at a bank, brokerage or mutual-fund company, and the accounts offer a variety of investment choices.
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There are drawbacks, of course. Individuals need to meet certain income thresholds to contribute—generally less
than $110,000 for single taxpayers or $220,000 for married couples who file their tax returns jointly. Unlike many
529s, the plans don't allow investors to take a state tax deduction for contributions. And many big savers will chafe
at the low contribution limits. Vanguard, concerned about changing tax laws, decided to stop offering Coverdells
this year to new investors.
One option for families whose income exceeds those thresholds is to have grandparents, who may be in a lower tax
bracket, open an account for the child.
• Savings accounts and bonds. Given the soaring costs of college, savings accounts aren't a good option over the
long term. But many advisers suggest that families planning to tap their funds in the next year or two should pare
back their stock-market exposure and transfer their money to more-conservative assets.
Despite rock-bottom interest rates, about 50% of parents saving for college say they now are using savings accounts
or CDs, according to a recent Sallie Mae survey.
Over the longer term, investors want vehicles that can provide solid inflation-adjusted returns. They might be
tempted by Treasury inflation-protected securities, or TIPS, whose principal and interest rate move in tandem with
the Consumer Price Index. But many advisers frown on using them for college savings, in part because the returns
aren't predictable. If prices fall and the U.S. economy enters a deflationary period, for example, investors can
potentially lose money with TIPS.
Zero-coupon bonds, on the other hand, can be a good option for investors who time them to mature in the years that
they need the cash for college, say advisers. Because the bonds don't pay interest during their life, investors can buy
them at a deep discount from their face value.
• Brokerage accounts. Some advisers are forgoing 529 plans entirely in favor of regular brokerage accounts, which
give investors more flexibility. If, for example, the child doesn't go to college or gets a full scholarship, the account
owner generally can't pull the money out of a 529 for other purposes without paying taxes and a 10% penalty on the
gains.
"There will be some taxes compared to the 529s, but the question is how much?" says Warren McIntyre, a financial
adviser in Troy, Mich. "I would contend it's not a lot." An investor could construct a low-cost portfolio of exchangetraded funds, for example, that would likely generate few capital gains until they are sold, keeping taxes lower, he
says. Investors could further reduce any taxes by offsetting any gains against investment losses elsewhere.
Families with young children should consider low-cost, growth-oriented ETFs, says Mr. McIntyre, such as a broad
U.S. stock-market fund from Vanguard or BlackRock Inc.'s iShares, adding bond funds as the child grows older.
• Retirement accounts. For families who want to keep their options open, funding a Roth IRA can allow for more
flexibility, advisers say. If the child gets a scholarship or decides not to go to college, the money can be used for
retirement. What's more, retirement assets generally aren't included in financial-aid calculations. And since the
contributions are funded with after-tax dollars, the original contributions can be withdrawn anytime without
penalties or taxes to pay for college if needed.
For 2011, Roths can be opened by couples who file joint tax returns and make less than $179,000, and individuals
who earn less than $122,000, though higher-income earners can convert existing IRAs to Roth accounts and take the
tax hit now.
Another option: setting up a standard or Roth IRA in the child's name and having the parents deposit any income
earned by the child—through a part-time job, say, or income earned through "household services" or a job in the
family business—into the account, says Deborah Fox, a financial adviser in San Diego who specializes in college
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planning. "That money is eligible to be used for higher-education costs without penalties for early withdrawal," she
says. (Ms. Fox now diversifies clients' college money across several 529 plans, custodial accounts and Roth IRAs.)
One downside: While retirement accounts are excluded from parents' assets in financial-aid formulas, distributions
from IRAs may count as income, which can hurt financial-aid eligibility. That is in part why Gary Carpenter, a CPA
specializing in college planning in Syracuse, N.Y., recommends that parents tap them after filing the last financialaid forms in January of the child's junior year in college.
• Insurance plans. Heads up: Investors' search for safer savings vehicles has opened the door to advisers pitching
more unconventional—and possibly costly—strategies based on insurance policies.
The brokers generally encourage parents to liquidate their 529 or other account or refinance their mortgage, and put
the cash in a whole-life or universal policy. Among the touted benefits: The cash value of the policy is guaranteed
and builds up over time. When it comes time to pay the tuition bills, the parents can take out a tax-free loan against
the policy's cash value—while the loans and assets are shielded from financial-aid formulas.
Ms. Fox, the college-savings adviser, says she has seen a surge in such insurance college-funding pitches from
clients asking her to review them. She discourages the strategy, as many of these contracts charge more than 3% a
year in fees and generate hefty commissions for the adviser. The strategies often assume a rate of return that is tough
to meet once the policy's expenses are taken into account, she says.
Even worse, investors are often required to lock up their money for long periods and could lose money if the insurer
runs into trouble. And lawmakers could always change the rules on tax-free loans before it comes time to take out
the money, leaving the holder in a bind.
• Borrowing. Given today's low interest rates, does it make sense to borrow to pay for school rather than spend down
savings? One rule of thumb is to compare after-tax interest rates, says Mark Kantrowitz, publisher of FinAid.org, a
financial-aid website. Taking money out of savings causes you to lose the return on investment. But if you would
otherwise be paying more interest on a loan, you would be better off spending the savings.
In most cases today, it is generally cheaper to use savings, where one might be earning around 1% to 2%, than to
take out a federal loan, where rates currently range from 4.5% on federally subsidized Stafford loans to 7.9% on
Parent Plus loans, Mr. Kantrowitz says.
College Loan Data
Coverdell Accounts
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Thanks to the recent tax deal, investors can continue to use Coverdell Education Savings Accounts for a
broad range of expenses, such as college and K-12 tuition. Average account size: $11,079
529 Plans
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Investors can withdraw earnings tax-free from 529 plans for qualified college expenses, but high fees and
mixed performance have hurt many plans in recent years. What the average 529 investment option lost in 2008:
24%
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Roth IRAs
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Investors can withdraw their original contributions from Roth IRAs without penalties or taxes for any
purpose—including college. Income limit to open an account, single filer: $122,000
Brokerage Accounts
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Investing in a brokerage account typically results in a tax bill, but a lowcost, well-constructed portfolio may
appeal to those looking for more flexibility and control. Percentage of money being saved for college in non-529
investments: 21%
Custodial Accounts
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Known as UTMAs or UGMAs, custodial accounts can be used for anything that benefits the child. Limit
after which income becomes taxed at the parents' rate: $1,900
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