In my previous Quick Introduction to 529 Plans, I laid out the basics of what 529 college savings plans are, how they work, and how you can use them to save and invest money for college and potentially grow your savings.
Now that you hopefully understand the basics, it’s time to take a look at what happens once you set up a 529 plan and you need to choose your investments.
In this article, we’ll take a look at typical 529 plan investment types and options, what choices you might have, and how your investments work once you’ve chosen them.
Let’s jump in and take a look.
Setting Up Your 529 College Savings Plan
When you set up a 529 plan, you choose an owner of the account and the beneficiary, and you enter required personal information such as names, addresses, and Social Security numbers. You’ll also decide how much money you’ll contribute to your plan. You can make an initial contribution in the form of a lump sum and then make regular monthly contributions, or you can just start with monthly contributions without an up-front investment.
Then you have to decide where the money will be invested. That’s when you’ll encounter the menu of options available through the plan you’ve chosen.
A 529 college savings plan is very similar to a 401K retirement plan that you may have at work, or an IRA where you’re doing some basic retirement investing on your own. A 529 plan offers you a menu of investment options, and you get to pick your preferred options.
Similar to investing with a 401K or an IRA, you can be more aggressive or more conservative with your investing, with different levels of risk and projected rates of return.
529 Plan Investment Options
Typically, there will be many investment options available with a 529 plan, such as aggressive growth funds, guaranteed or certificate of deposit (CD) accounts, small-cap and international funds, and age-based investment options where your money is automatically invested more aggressively when your children are young and more conservatively when they’re closer to college age.
However, for simplicity, there are three fundamental types of investments at the core of any 529 plan’s options:
Let’s take a look at each of these in more detail:
If you invest in stocks, you’re investing in individual companies, and you become an owner of that company. Companies sell shares in stock markets to raise money, and investors buy and sell stocks based on their potential to go up in value or pay dividends.
With many stocks, as an owner and holder of a stock certificate, you are entitled to a share in the company’s profits, in the form of monetary payments called dividends. Not all stocks pay dividends, but many do.
Additionally, a stock’s value can potentially appreciate based on its potential to increase in value or issue dividends, and if its price goes up, you can sell it for a profit.
Historically, stocks have an overall high rate of return and their values increase, but there is risk involved. Stock prices can fluctuate, stocks can go down in value, and companies can potentially lose money rather than generate profits, which means they can’t pay out dividends.
However, over the past 100 years, based on data from extensive studies, stocks typically generate positive returns over periods of 5 years, 10 years and especially 15 years.
If you invest in bonds, you’re lending a company money. To raise money, companies issue bonds, which are debt obligations. You’re able to purchase those bonds at the company’s asking price, and the principal is loaned to the company for use in helping it develop new products, hire more staff, pursue growth projects, etc.
In exchange, the company makes a legal commitment to pay you interest on the principal you’ve loaned the company, and, in most cases, to return the principal when the bond comes due or matures. Unlike a stock, a band doesn’t give you any ownership stake in the company. Instead, you’re essentially a lender to the business.
Similar to stocks, however, bonds carry a certain amount of risk. If a company is unable to pay you the interest or unable to pay back the principal it owes you once the bond is due or matures, then you could lose money on your investment. But if you like the company, its risk profile, and its potential, then a bond investment may make good financial sense.
A 529 typically offers opportunities to invest cash, which basically means investing your money in either guaranteed savings accounts or certificates of deposit (CDs) with a bank.
Since the FDIC insures cash deposits up to a sizable amount, your money is very safe. But interest rates on cash investments are quite low. Banks don’t pay much interest, so you might get only 1% or 2% interest on a CD and only 0.25% or 0.5% on a regular savings account.
This means you probably won’t make a lot of money on your deposit or investment, but your money is very safe. That’s the tradeoff. Cash investments are a good way to diversify your 529 plan portfolio and create a good balance of investment risk and return.
However, another downside with cash is that purchasing power decreases as years go on, and the interest the bank pays and your rate of return may not keep up with the growth of inflation. If it doesn’t, and something that costs $100 today ends up costing $120 in 10 years, if your return only gives you the equivalent of $105 or $110, it doesn’t give you the same purchasing power.
This is why a lot of people invest in the capital markets via stocks and bonds, because they want to at least keep up with inflation and keep their purchasing power. On top of this, if their investments do well, they may actually end up well ahead of inflation and may have even more purchasing power.
Ultimately, stocks and bonds are a good way to fight inflation and maximize your investment, whereas cash is an excellent way to minimize risk. When you combine these investments in a diversified 529 plan portfolio, you can potentially get a good return while managing your overall risk.
The Importance of a Diversified 529 Plan Portfolio
Since the cost of college has increased dramatically over the past 30 years, and since it will continue to rise due to inflation, most families will end up investing in some stocks and bonds as part of their 529 plan. These investments carry more risk, but they also generally generate a much higher return.
However, diversifying your portfolio is really important because stocks and bonds aren’t a guaranteed return.
For example, back in the earliest days of social media, both Facebook and MySpace with big players. If you had invested in Facebook when it first went public and started issuing stock, you would have made a lot of money. But if you had invested in MySpace instead, you may have lost all or the vast majority of your money because MySpace ultimately didn’t succeed.
Fortunately, you don’t have to invest all of your money in one company or one type of investment. With a 529 plan, you have many options, including mutual funds and exchange-traded funds, which invest your money across a diverse variety of stocks and many different companies and industries.
Many 529 plans also have financial products that diversify things for you automatically. They have stock funds and bond funds and cash accounts, but they’re all diversified across many stocks for the stock funds, many bonds for the bond fund, and often many banks for the cash account.
You can also work with a financial advisor who can provide guidance and help you choose the right options and invest your money in the smartest ways to manage your risk while generating the right projected return.
If you’re already working with a financial advisor, now is a crucial time to consider whether your current advisor can help you with 529 plans or whether you should seek a 529 plan expert. If your current advisor hasn’t already been working with you on a 529 plan and bringing this to your attention, then you probably have the wrong advisor.
As a reminder, there are tax benefits with 529 plans as well. You don’t have to pay federal taxes on any money you withdraw or any gains you’ve made, as long as you use the money to pay for qualifying educational expenses. In many states, you don’t have to pay state taxes on your 529 withdrawals or gains either.
Crucial Advice About 529 Plans
Before you invest in any state’s 529 plan, you should carefully consider your investment objectives and any risks, charges and expenses. This information is contained in fund prospectuses, summary prospectuses, and 529 Product Program Descriptions and other documents, which are available from a financial professional or directly from a 529 plan’s website.
Read this information carefully before investing. Some 529 plans are better than others because they offer more investment options or lower fees.
Also, it’s important to consider how 529 plans work in your state. For example, do you get a state tax deduction for contributing to a 529 plan? If you don’t, then it might be worthwhile to look outside your state to see if there are any plans that offer more investment options and/or lower fees. But if you’re in a state that offers additional tax benefits if you use one of its plans, then you might want to keep your money closer to home.
It’s also a good idea to consult a tax professional, to make sure you understand the state and federal rules around how you make your withdrawals and how you can use your funds on qualified expenses. If you use your money for purposes other than qualified expenses, then your withdrawals can be subject to a 10% federal tax penalty, state penalties, and federal as well as state income tax.
How to Open a 529 College Savings Plan and Start Choosing Your Investments
To learn more, you can contact me for expert guidance as you look to choose and open a 529 plan and select your investments.
As a Certified Financial Planner, I’ve been helping families plan and save for college and invest their money wisely for over 20 years. I can quickly answer your questions, point you in the right direction, and even serve as your 529 plan advisor if you’re in one of the states that I serve.
To get started, contact me now.
Registered Representative, Securities offered through Cambridge Investment Research, Inc. a Broker/Dealer, Member FINRA / SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Baldridge College Solutions and Cambridge are not affiliated.
This communication is strictly intended for individuals residing in the states of California, Colorado, Florida, Georgia, Iowa, Illinois, Indiana, Maryland, Minnesota, Missouri, Montana, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Texas, Utah, Virginia, and Wisconsin. No offers may be made or accepted from any resident outside the specific states referenced.
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