Rethinking the 529 College Savings Plan Strategy

For years we've been plowing money into 529 plans for our children (after, of course, contributing to our retirement accounts as well), knowing how painful it's going to be 10-15 years out when we start getting those tuition bills. Generally, I've always been a strong proponent of relying heavily on stock market returns over long periods of time since they tend to outperform all other asset classes in periods of 10 years or longer (with 2000-2010 being a notable exception). As such, we have our 529 plan portfolios set up to invest in the most aggressive stock portfolios I could find, with the intention of shifting gears into more conservative stock/bond mix portfolios as the kids reach their teenage years in order to protect the principal in the event of a downturn like what we saw in 2008 and 2009. However, I'm starting to rethink this approach.

529 Investing — Buying Tuition Credits or Investing in Stocks

The reason I'm rethinking my strategy has little to do with the market downturn in 2008 and 2009. I'm not easily influenced by "the recency effect," and I don't change long-term strategies unless there's a game-changing definitive driver. Rather, the input that's making me rethink our strategy is the trajectory of college tuition costs and the prospect that there's no relief in sight. (See also: Beyond Tuition: Helping Out With College Expenses)

The most recent survey of college tuition costs from The College Board indicates that for the 2010-2011 school year, in-state tuition and fees will rise 7.9%, a staggering number. Private schools will see their costs increase 4.5%, but being mindful that private schools are generally 3-5 times more expensive than a top state school (and hence prohibitively expensive for us to fund fully), it's the state-school tuition hike that we're paying close attention to. Debt-burdened state budgets are facing an uphill battle, confronted with interest payments coming due mixed with declining tax revenues from a stagnant economy. I'd like to be more optimistic, but the pragmatist in me views this as a longer-term issue with the net result being continued lack of funding for public universities. As a result, it won't suprise me if we continue to see hikes of 7-9% for years to come.

Changing Strategy — What if I Guess Wrong?

By having prepared, and either saving a hefty amount in the 529 plan in a stock/bond mix or having purchased several tuition credits in advance, at least we will have taken a step in the right direction, no matter which option turns out to be the better investment. However, if it turns out that stocks average 2% or 12% over the next 15 years, buying tuition credits in advance will have either looked like a genius move or an overly conservative lost opportunity. In order to have it both ways, I'm actually going to look to start a new 529 plan to purchase tuition credits while retaining the aggressive market-based portfolio in my other plan. This way, I've mitigated my risk substantially. As far as weighting, I think I may start funneling money more heavily toward the credit option because the chances of college tuition costs dropping dramatically over time seem slim, as does the prospect of stocks having "above average" market performance, given that we're coming off a massive 75% gain from the pivot bottom in March 2009, and we're likely looking at very low single-digit GDP growth for years.

Multiple 529 Plans Are Allowed

Since most 529 plans don't have state residency requirements, you can usually have accounts with multiple state plans. Since I started with the Ohio savings plan due to their portfolio selection and low fees, I can actually do a state tuition credit plan in my home state. So, legally and practically speaking, my plan is achievable.

By buying credits each year that are expected to increase at 8% or more, that's essentially my "investment return." What makes, say, an 8% return on college tuition credits so much more attractive than an 8% return in stocks is the lack of volatility. While stocks will continue to see-saw up and down with no guarantee of beating 8%, college tuition increases over the years. Thus buying tuition credits is the equivalent of earning a very high "risk-free return," which is presently in the very low single-digits for savings, CDs, and Treasury bonds. The intangible risk we're already taking on is that we'll save too much if one or more of our children doesn't go to college. Fortunately, there's ample flexibility built into 529 plans to redistribute savings to other family members or withdraw the money with a penalty as a last resort.

What's your approach to 529 plan savings?

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Guest's picture

Your plan sounds good to me. Actually, a lot of state universities have raised their tuition 12% or more each year for the past 5 years. I have four children in college right now, and three are at Auburn University, which has raised tuition each year they've been enrolled - and it's always been 12% or 12.5%. Books have not gotten cheaper either, nor have living expenses.

Darwins Money's picture

That's amazing - 12% per year? Imagine being able to match that in stocks year after year! Definitely hedging my bets here.

Guest's picture

Good article but there are a few other things to consider. Hopefully your 529 account will increase annually and there will be compounding at work. In addition, there are states (like New Jersey) that have a matching program up to a certain amount - $1500 in New Jersey- if your child goes to an in-state school.

Hollis Colquhoun

Darwins Money's picture

Hi Hollis,
Thanks for your comment. I certainly anticipate some annual increase given the aggressive stock mix, but for my apples to apples comparison, with tuition increases at say, 7% per year and stocks increase at 7% per year as well, it's a wash. If tuition spikes higher and stocks sputter, I will have been better off with the tuition plan, so hedging bets with both options moving forward.

It's always interesting to hear how each state has their own nuances for their plans; sounds incredible there in Jersey if they're matching! That's great, most states don't have an all-out match, often just a tax deduction.

Julie Rains's picture

I would love to buy a pre-paid plan for a public university but those aren't available in my state. The 529 promise of locking in prices early through pre-paid credits was great but the majority of states opted out of that set-up so you're right to scrutinize various plans. Obviously, you can sign up for a savings plan in one state but I wouldn't think that tuition credits would transfer the way that cash would. Certain private schools do participate in prepaid programs so if you know where your child will be attending and that college is on the list, that could be a great way to start saving (and hedging).

I wrote about savings vs. prepaid plans earlier as well in case anyone is interested:

Darwins Money's picture

It's very state-centric unfortunately, but there are states that do allow the tuition credits to transfer (roughly) like cash. What they do is they set up tier levels for credits, like "public", "private top tier", "Ivy League", etc., and those credits have varying costs of course. However, as the costs inflate over the years and as you buy credits, your child will be allowed to exercise those credits at any of the schools within those tiers, even if it's in a different state.

This complexity is one of the reasons I initially avoided the pre-paid plans and figured I'd go with a sure thing in market returns. But back then, I assumed 4-5% annual hikes would be the norm. Now that we're at 7-8% routinely, definitely worth a look.

Guest's picture

One thing to consider is flexibility. I know some schools allow you to pre-purchase tuition, but you run the risk of your child not wanting/qualifying for that school. For example if you chose University of X, known for their engineering program, but your child desires a law program.... you're stuck.

Darwins Money's picture

Good Point. At this point with only one income we're probably going to focus on the state school option since the credits are more affordable and allow for flexibility. Also, since we have 3 children, we'll have some ability to shift credits/funds around between the children since they're portable. With a single child, the strategy might be more risky. There's always the possibility that a child doesn't attend college at all, at which point, you can have the money refunded, but with a penalty (unless you're gracious enough to transfer it to an extended family member).

Definitely not an arrangement to be taken lightly...

Guest's picture

I second this. Even though you can't afford private sticker price, your children might qualify for need-based aid, and/or win merit scholarships. If, factoring in scholarships, a private school your kid loves turns out cheaper than the state school, but your college savings are already locked into credits, that's a sad missed opportunity.

The most elite 20 or so private colleges in America don't have merit scholarships, but the tier right below that generally does. Excellent schools with merit money up for grabs include Grinnell College, Washington University in St. Louis, Claremont McKenna, Olin College of Engineering, Emory University, Duke University...the list goes on. As for the other 20, they tend to take a very generous stance on need-based aid. For instance, here's a fact sheet on financial aid at Harvard:

Guest's picture

Our daughter is a senior this year. We saved with a 529 and a trust in our daughter's name. The trust was a bad idea because it hurt her eligibilillty for need based financial aid. Fortunately, she got a $10K Scholarship/year that helped with costs. She also took out a small loan. Finally, we paid some of the bills out of current income. It's a difficult issue but I think your assumption that costs will continue to rise is apt.

Guest's picture

I did quite a bit of research and asked a number of wealth managers and I ended up selecting a low cost 529 plan that uses Vanguard funds (I live in Washington State, but selected the Utah plan). Over the long term, I hope this is the right approach based on a similar theory to what you suggested in this article. However, WA's college savings plan (callege GET), which is based on pre-paid credits, has significantly outperformed the stock market over the past few years as a result of continued tuition increases. The GET program is a low risk and I am now rethinking my strategy as well, or at least I plan to hedge my bet and invest in Utah and GET!