Building a bridge to college financing: with college costs rising out of control and financial markets in turmoil, 529 plans can save the day—if managed properly

Black Enterprise, April, 2004 by Kelly D. Herd

Three years ago, Robin Walker didn't have any money invested to cover either of her children's post-secondary school costs.

While the legal secretary made a reasonable salary, she knew she wouldn't, be able to send daughter Sheriden and son Clinton, who were 13 and 10 at the time, to college while maintaining her current standard of living.

So when Walker heard about 529 college savings plans (state-sponsored investment accounts) on the job, they sounded like a relatively easy, tax-free way to invest for her children's college education. These plans give you the ability to invest money in a pre-selected portfolio of stocks and bonds for future use toward educational expenses. They "also provide tax-free savings on the interest earned, as long as the money is used for education. Some states even offer a tax deduction for state residents.

The 529 plan option seemed like an even sweeter deal when the Washington, D.C.-based law firm where Walker works offered the plan as an additional savings vehicle for its employees. "I have other investment accounts with my employer and I trust what they offer," says Walker, who placed $1,500 in Maine's NextGen College Investment Plan for her daughter and $500 for her son. She made monthly contributions of $500 and $200, respectively.

Unfortunately, within a year of setting up her 529 plan, Walker watched the declining market chip away at her children's education funds. Managed by Merrill Lynch, the NextGen College Investing Plan was down 22.8% through the first three quarters of 2003. A large loss prompted Walker to discontinue regular contributions to the plan for daughter Sheriden. "I just felt the market was too risky with college just around the corner," she says.

The stock market's negative trend has been especially troublesome for parents like Walker who have children nearing college age. Many are worried about having to raid their retirement funds to pay for college costs. And with good reason: Next to buying a home, paying for college--public or private--is one of the biggest expenses a family will incur. Public college and university costs rose 14% in 2003. According to the College Board, a national nonprofit association that connects students with college opportunities, one year at a state school, including room and board, costs around $10,636; a private school costs $26,854.

Walker will rely on other resources when she sends Sheriden off to college in 2005. Because she has time on her side with Clinton, she's leaving the $7,000 currently in the 529 plan, hoping the market takes a turn for the better before it's his turn for college.

Parents have a varied number of college financing options, but the most popular tools of late are 529 college savings plans. About $30 billion in assets is now invested in 529 college savings plans and investors are expected to add some $50 billion more by 2007.

While a 529 college savings plan is an important new saving and investing tool, parents need to be "better schooled," says Joseph F. Hurley, CEO of Savingforcollege.com in Pittsford, New York, and author of The Best Way to Save for College: A Complete Guide to 529 Plans (Bonacom Publications; $22.95). Hurley notes that the benefits of investing in 529 plans are that, unlike most other tax-advantaged savings plans, you can start out making very small contributions, there are no age or income limits, and they allow extremely high contributions. But many plans charge management fees, some higher than others, and many plans have limited investment options. And an added wrinkle is that several state plans invest in mutual funds that have been implicated in the federal government's investigation of mutual fund trading violations. Strong Capital and Putnam Investments are among those companies implicated in the scandal. (See "Caught in a Storm," this issue.) But parents shouldn't be dismayed, says Hurley. To get the most bang for their buck, "they just have to understand how 529 plans work and how to manage them," he says.

SIZING UP 529 PLANS

There are two kinds of 529 plans, which get their name from section 529 of the tax code: prepaid tuition plans, which let you lock in the price of your child's future tuition by prepaying at today's rate now, and college savings plans, which are investment programs that let you make account contributions toward a beneficiary's qualified higher education expenses (tuition, fees, room and board, books, and supplies). The IRS imposes a 10% penalty as well as income taxes on gains for unqualified withdrawals.

With a prepaid tuition plan, parents, grandparents, and other interested persons can purchase units that can later be redeemed for a percentage of tuition at, any of that state's eligible colleges or universities. The maximum contribution is the amount necessary to prepay the number of years the child is expected to attend that state's institution of higher learning. Tuition credits can also be applied if your child chooses to go to an out-of-state school.