Saving for a kid's college can feel like trying to scale a skyscraper. Unfortunately, the tool most recommended to parents for the challenge is often little better than a step stool -- one known to wobble.
The appeal of 529 college savings plans is that investment returns aren't taxed as long as the money's used for education. States set the investment options, and often add on additional tax incentives. Despite these perks, less than 3 percent of American families use the plans. Those who do use them are disproportionately wealthy, with 25 times more assets than those who don’t use the plans, according to the Government Accountability Office (GAO).
It's easy to see why Americans don’t embrace 529 plans. They often have limited investment options, high fees, complicated rules and anxiety-producing investment risks. All that said, the plans may ultimately be worthwhile for most families, as long as parents choose carefully.
Focusing on fees is crucial. In 2012, the GAO found some plans charging up to 2.78 percent of assets per year. Fees that high can wipe out any tax savings the plans provide, and then some. The only people those plans help to afford college are the brokers selling them.
Fees vary widely from state to state. In Louisiana, there’s no fee at all on a basic plan for residents, thanks to state subsidies. Savers can often use low-cost plans in other states, though they may forfeit a state tax deduction by doing so. And luckily, some fees are falling. In January, T. Rowe Price will drop the program management fee on most of its 529 plans to 0.13 percent from 0.2 percent, though there's an additional fund management fee of up to 0.68 percent. Vanguard Group, the lowest-cost of the major 529 providers, just dropped the total expenses on its age-based funds to 0.19 percent from 0.21 percent.
To make a 529 plan pay off, savers want to be in stocks, which tend to produce bigger returns over the long term. But stocks are unpredictable, and college savers often don't have much time and flexibility to ride out market downturns. Returns can depend on luck. A hypothetical student in the college class of 2000 would have done great in a 529 plan, as her plan’s value increased 236 percent since birth, the think tank Education Sector calculated. A class of 2010 student would have seen her account rise only 14 percent.
To deal with this wildcard, some plans automatically lower portfolio risk as college approaches. So a seven-year-old will have a much bigger chunk in stocks than a 17-year-old. This doesn't always protect against a big loss, however. In Maryland, Virginia and North Carolina in 2008, some accounts for children about to enter college dropped 30 percent.
Another downside is that money in a 529 can't easily be used to cover a medical emergency, a drop in income or a house payment. Withdrawing money for non-educational reasons means paying taxes and a 10 percent penalty. But the tax and the penalty only apply to any investment gain. Whatever amount was put into the 529 comes back tax- and penalty-free.
Despite the potential drawbacks, the tax savings can add up in a 529 plan compared to a taxable investment account. Households in the top bracket can boost college savings 39 percent with 529s, a 2009 Treasury Department analysis found. Married couples with income of $137,000 to $209,000 got a 35 percent boost, the analysis found, and families earning less than $68,000 saved 22 percent more.
So while 529 plans have flaws, a low-fee plan is a better option than leaving money in a low-interest bank account that can be raided for frivolous purchases. With college costs up 1,225 percent since 1978, parents need all the help they can get.
More stories by Ben Steverman:
- Retirement Royalty: Where Workers Still Get a Pension
- How to Procrastinate Better
- Stocks are Red Hot. Investors are Cold Sober
Follow @bsteverman on twitter