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The 529 college savings plan is widely regarded as one of the most tax friendly tools available for funding your child’s future tuition, but how you invest within those plans can make a big difference in your potential return and, more importantly, level of risk.
While 529 plans differ depending on the state that sponsors them, most offer a selection of funds. Investors can typically choose which type of investment strategy they wish to deploy — either static, in which they select an asset allocation which is up to them to adjust, or “age based,” in which the account automatically becomes more conservative as their child approaches their college years. (Calculator: How much should I save for college?)
Neither is the better option, but 529 plan account owners should understand the difference between both investment strategies, the potential impact on their future account balance, and the risks involved.
529 college savings plan definition
A 529 saving plan is an investment account that enables families to save for future college costs on a tax-favored basis. While contributions are not deductible, any earnings in the account can be withdrawn tax free if used to pay for qualified education costs — including tuition, fees, books, and room and board.1
As of 2022, qualified education costs now includes up to $10,000 in annual expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.
Earnings from a 529 plan that not used for qualified expenses will not only be subject to income tax, but also generally hit with an extra 10 percent penalty. (The penalty is typically waived in the case of a death or disability, or if your child receives a scholarship.)
Take note that if your child chooses not to attend college, you can generally change the beneficiary and pass any unused money in your 529 account along to their siblings penalty-free — or nieces and nephews. Of course, that money must still be used for qualified education expenses. (Learn more: Alternatives for 529 savings)
Most states sponsor their own 529 plans, and some (not all) offer a state income tax deduction or credit to residents who participate in their plan. Investors, however, are not restricted to their own state’s 529 — they can participate in any 529 plan they choose. And, the money they accumulate in their plan can be used to cover costs at any qualifying college or university in the country.
By contrast, a 529 prepaid tuition plan is not an investment at all. Rather, as the name implies, it enables individuals to purchase credits based on today’s in-state tuition costs for use by their child in the future — effectively locking in the current cost of tuition. Kids who select a private or out-of-state school generally get back the equivalent of current in-state public college tuition, and pay the difference on their own. Prepaid 529 college savings plans do not generate a return based on market performance, but they are also devoid of market risk. (Learn more: Savings vs. prepaid 529 plans)
Is the age-based 529 model for me?
For many parents, especially those who seek to generate modest returns while also managing risk, the age-based 529 investment model is an appropriate fit, said Joseph Spada, a senior principal for Summit Financial Resources in Parsippany, New Jersey, in an interview.
“I don’t mind being a little more conservative with college savings, especially if you don’t have much time before your kids head off to college,” he said. “If you are too aggressive and the market turns against you right before they graduate from high school, you could end up with half of what you need for college.”
The age-based strategy, he said, is a “set it and forget it” solution in which the portfolio is heavily weighted to stocks until the beneficiary (college-bound child) reaches about middle school, at which point the asset allocation gradually shifts to include a higher percentage of cash and bonds — securities that traditionally generate lower returns in exchange for lower risk. (Past performance is, of course, no guarantee of future returns.)
Because age-based plans automatically adjust over time, they also may be ideal for families who do not have the time or tools to monitor their 529 portfolio.
“Most parents don’t want to commit to rebalancing their 529 portfolio on their own and they may not know how to manage it properly, so the age-based strategy takes that out of their hands,” said Spada. “When the market is not doing well people tend to not put new money in, or they get spooked and put too much money into fixed income (which historically generates lower returns).”
Scott Moffitt, a financial professional with Summit Financial Group in Loveland, Ohio, agrees: “For most families, I personally believe age-based funds are probably the right answer from a strict academic standpoint, given the time horizon they have.”
The 529 plan age-based strategy helps to minimize the risk of having to potentially liquidate your equity-heavy portfolio in a down market when the first tuition payments come due.
But that peace of mind can also come at a cost, depending on your financial goals. A portfolio that is heavily weighted to cash and bonds, for example, may not generate the kind of returns you need to meet the rising cost of higher education.
For those who have sufficient resources outside their 529 plan, or cash value in a life insurance policy that they may borrow from for college tuition expenses, an investing approach based on age might be too conservative, said Walter Katz in an interview, a financial professional at MassMutual Greater Houston. (Learn more: Treat cash value with care)
“I believe an age-based strategy can potentially be too conservative if you need more growth and therefore are willing to take on more risk and live with the volatility,” said Katz.
What is a static 529 plan?
More experienced investors who are willing to assume greater risk in exchange for the potential to attain higher returns, may instead wish to select a static (or build-your-own) 529 investment plan, he said.
Static 529 portfolios enable investors to target a specific risk level, such as “growth” or “aggressive growth,” or create an individual portfolio that tracks underlying mutual funds, exchange-traded funds or other investments, according to Savingforcollege.com.
The asset allocation in such plans does not change over time, unless the account holder requests it.
Static plans are also the tool of choice for the highly risk averse; those who merely wish to put money into a relatively “safe haven” bond portfolio that is designed primarily to preserve principal (or their contributions) and not generate higher returns.
Moffitt said in an interview that he personally uses a static plan for his own 529. “I am knowingly taking on more risk, but I know that if the market were to drop substantially tomorrow I may not be able to recover in time for my daughter who is a sophomore in high school,” he said. “Because I have younger kids, though, I also know that I could leave that money in the account, wait for it to recover, and use it for them as long as I haven’t fully funded their accounts.”
Those who select a static, or customizable, 529 plan strategy, however, must be sure they have the discipline to stay true to their investment strategy when the markets ebb and flow. Many investors are prone to knee-jerk reactions in times of market turmoil, Spada said, moving into fixed income when the going gets rough, or halting contributions altogether, which can hurt their future account balance more significantly than any investment strategy they select.
“Most people don’t manage self-allocated accounts well,” said Spada. “When the market is not doing well, they stop putting new contributions in, or they get scared and move all their money to fixed income. That’s the challenge with people trying to balance it themselves.”
Compare 529 plans
Families who are considering opening a 529 account should be sure the investment strategy they select matches their tolerance for risk and need for returns. (Related: Getting the most out of your 529 plan)
Indeed, even among age-based plans, the differences can be great. Some continue to invest 20 percent or more in equities while the beneficiary (student) is in college, which may make sense for those who started saving late and need to assume more risk to pursue higher potential returns, said Katz.
Other age-based plans move out of equities entirely, and into cash and bonds, when the student turns 18 in a bid to mitigate market losses.
Savingforcollege.com offers an online tool to help families compare the fees, performance, and overall rating of individual state 529 college savings plans.
You can, of course, change your 529 plan investment options over the years as your financial picture evolves. (Related: 10 mistakes to avoid with 529 savings plans)
Keep in mind, too, that you need not select merely one investment strategy for your 529. For some families, Katz said, the best solution is to diversify. “The solution many times I think is to split your investment,” he said. “If you are planning to put $10,000 into your account for the next 10 years, you may want to put 50 percent of that into an age-based portfolio and the rest into a build-your-own (or static) portfolio where you can be a little more aggressive.”
He notes, too, that those saving for college may also be positioned to assume greater risk in their 529 portfolio if they otherwise have sufficient assets in an IRA or cash value life insurance policy from which they could potentially borrow for college expenses penalty-free. Be aware that borrowing against life insurance cash value increases the chances that the policy will lapse, reduces the cash value and death benefit, and may result in a tax bill if the policy terminates before the death of the insured.
“It’s not all or none with your 529 plan,” said Katz. “I like splitting buckets not just within your asset allocation, but among financial products. If you have $200,000 in an IRA, plus some life insurance cash value, you may be able to be more aggressive in your 529.”
Most financial planners, however, note individuals should avoid borrowing from their retirement account to pay for their child’s college education, since scholarships and low interest loans exist for tuition assistance. And borrowing from an IRA or permanent life insurance policy might compromise your retirement goals or your life insurance death benefit for your heirs.
The 529 investment strategy you select will not only impact the volatility within your portfolio, but likely the size of your future account balance.
Investors need to consider their options with care, educate themselves on the implications of both an age-based and static option, and come to terms with their personal tolerance for risk. A financial professional can help you find a plan that fits your needs.
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This article was originally published in October 2016. It has been updated.
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¹Internal Revenue Service, “Topic No. 313 Qualified Tuition Programs (QTPs),” Oct. 3 2022.