The 529 College Savings Plan: What You Should Know
LYNN NEARY, Host:
Many young people searching for summer jobs are trying to find ways to earn money for college. Another strategy for parents of college-bound kids to save has been the 529 plan. Americans have contributed millions to these funds over the years. But in this economic environment, are 529s the best way to pay for school? Who better to ask than our personal finance expert, Alvin Hall. Good to have you with us, Alvin.
ALVIN HALL: Glad to be back.
NEARY: Now I know there are a couple of different types of 529 plans. Can you explain the differences?
HALL: Yes. The basic 529 plan is sponsored by the state, and in this case parents can front-load the plan. They can contribute an amount equal to five years contributions to the plan. The other type is known as the Coverdale Educational Savings Accounts. This is more like a traditional IRA, where people can put up to $2,000 a year into this for their children's education. And this is capped by certain income limits by the parents. So beyond a certain level, parents - beyond a certain income level, parents have to go to the 529 plans.
NEARY: What about prepaid tuition plans? Is that part of the 529 plan?
HALL: That's part of the 529 plans. Actually, they're slightly separate, where they can pay the tuition. Those are state-run plans, also.
NEARY: Okay. Now why do people choose 529s over any other college saving plan?
HALL: Oh, the best reason that all of the gains that you make in those programs are tax-deductible - sorry, wrong, that all the gains you make are not subject to taxes during the growth of the program. That's why people like it. The money that you put in is with after-tax money, but all the gains you make up to $250,000 per dependent, you have to pay no taxes on that money as long as it's used to pay for something related to the kids' education.
NEARY: All right, I wanted to ask you about these prepaid tuition plans first.
NEARY: Can you explain what they are and how they work exactly?
HALL: These are mostly arranged in states with certain institutions where you can pay all of your tuition for your student or a substantial part of it beforehand. These are very attractive if you know where your kid is going to go, how much that tuition is going to be, and often the institutions will offer you a financial person or some advice about how much money you need to put away to cover the tuition over the period of time.
NEARY: But aren't some of these prepaid tuition plans running into trouble now, and people are finding that they thought that it meant that the guarantee that college tuition would be paid for, and that's not the case?
HALL: Well, you know, it's interesting you should say that. They're running into programs - I think because of the language issue, I think people did think they were guaranteed. But as always, these things were invested, and any time you have investment involved, that will involve a degree of risk. And I don't think that risk was adequately or accurately explained to the people who put the money into these programs.
NEARY: So should people stay away from the prepaid tuition plans now, do you think?
HALL: I think, for my opinion, I think everybody should go for the 529 plans. I think they are clearer. I think the regulations are much more consistent. And you don't - the products that are available to you are really reasonable product and have been subject to long-term analysis.
For example, most of the 529 plans, you get to invest in mutual fund. Mutual funds have been around forever. So how you analyze those mutual funds and how you put that money away into them is much more of a traditional system that people can more easily understand, I think.
NEARY: But what about in the current market? A lot of these plans do seem to depend on relatively high-risk investments.
HALL: Well, that's not necessarily true. I think, first, that some of the states did very poorly in choosing the types of mutual funds that were available to the people who signed up for these plans. I think that that was unfortunate. They did not look at the risk analysis of them, and they certainly didn't look at the expense ratio of the mutual funds that are involved in these programs.
So I think yes in some states, but in other states they did a better job. I think as it moves forward, everybody's learning from their mistakes, but understanding your risk and having the ability to adjust the risk as your child moves more and more toward going to college is a very important feature of these programs.
NEARY: Do any of these 529 plans have hidden fees? We keep hearing about hidden fees on all kinds of things these days. I'm wondering about these plans, as well.
HALL: Well, some of them have small fees, but the big fee is the expense ratio of the mutual funds that you put the money in. People look at mutual funds and they think they're all the same. Look at the expense ratio. In some cases, they can be as high as one-and-a-half, you know, two percent per year. You should look at those with the lowest expense ratios because then more money goes toward your child's education over the long term.
NEARY: You know, I think these days a lot of people think they'd probably do better maybe with a savings account or a money market fund than with mutual funds.
HALL: I'm a big fan of those, especially if you are risk-averse. One of the things that happens with these programs, when people go into them, they're very optimistic, and they sort of suppress the idea that they could lose money in these programs. They are investments, and you should recognize that as you move toward the time you will actually have to use that money, that you need to have that money quite safe and in a good place like a money market account, like a savings account or a CD.
So as you move nearer the time you're going to need that money, move it to something safe. Don't just leave it in the stock market.
NEARY: You know, a lot of people have lost a lot of money in these funds at this point, and they may just be throwing up their hands and saying forget about it. I'm not going to even save anymore. Is there a point where it's too late to start saving for college if your kid is just a few years away from going at this point?
HALL: No. You may want to shift your strategy and then save the money as cash and earn interest on the money. Putting some money away for your child's education is very useful. I think about my own education where, you know, I didn't have money for books sometimes or even money to cover food costs. And luckily I had a scholarship to help out with those costs. My parents didn't contribute anything. I think any little money you can put away is very good. However, if you are risk-averse, put the money in something that is safe. Do not invest it.
NEARY: Even if it's just a few years away.
HALL: Even if it's just a few years away because look at what happened. Could we have predicted the stock market was going to drop by as much as it has? All that money that's been in there has been washed away, and what a lot of people are doing, as you're saying, they're throwing up their hands and taking their losses and saying, let me put the money in something safe. That's a reasonable strategy in this particular market.
NEARY: And we're all hoping that our children are going to get scholarships just like you, Alvin.
(SOUNDBITE OF LAUGHTER)
HALL: We can hope, and many kids will. I tell everybody, go to the school or university to which you're applying, talk to the financial aid people and see what packages or combinations of grants, loans or even scholarships are available to you at those institutions.
NEARY: All right, personal finance expert Alvin Hall joined us from our bureau in New York. Alvin, great to talk to you, thanks.
HALL: Glad to be back.