College Saving Gets Trickier

College Saving Gets Trickier

Burned by your 529 plan? There's a chance that your provider has sweetened the deal. But recent tax changes may make other strategies more attractive.

By JANE J. KIM

Families need to know which college-savings vehicles make sense right now -- and which don't.

After being pilloried by critics and written off by many families, 529 college-saving plans are getting better. But well-heeled investors still would be wise to spread their bets around.

So-called 529 plans allow people to save for college expenses and withdraw the earnings tax-free. Many also offer a break on state income tax—savings that, in theory, an investor can roll back into the account.

For years 529s were pitched as the ultimate college-savings vehicle, but their limitations were thrown into sharp relief during the financial crisis. Too reliant on stocks, the average 529 investment option lost nearly 24% in 2008.

Even portfolios geared to older kids just a few years away from college got hammered, losing 14%, according to investment-research firm Morningstar Inc. What's more, because savers can generally make investment changes only once a year, many people watched helplessly as their accounts dropped in value.

From safer 529s to retirement plans, WSJ's Jane Kim and SmartMoney's AnnaMaria Andriotis discuss which college-savings vehicles make sense right now--and which don't.

The plans have other well-known shortcomings. Many states, for example, charge additional plan-management fees, so the average fees tend to be higher than their mutual-fund counterparts, according to Morningstar, which recently started rating 529 plans (available at

Performance, meanwhile, has been a mixed bag: According to Morningstar, 529 plans lagged their retail mutual-fund counterparts in four out of seven fund categories on an annualized basis over the five-year period ended October. And most of the plans still offer limited investment options or investments run only by the program manager—though more states are adding third-party options.

The problems prompted some families to pull back. In 2010, for the first time, they took out more money than they added in any one quarter—$113 million in net outflows in the three months ended Sept. 30, according to the College Savings Foundation, an industry group. The foundation says the distributions reflect the fact that more families now are tapping the plans to pay for college.

The industry is addressing the criticisms by dropping fees, rethinking asset allocations and adding more options, such as low-cost index funds and bank products, including certificates of deposit and savings accounts. Last month, for example, First National of Nebraska's First National Bank of Omaha took over three of Nebraska's 529 plans from Union Bank & Trust Co., and promptly lowered the program manager's fee to 0.26% from 0.6%, expanded outside investment options and made the portfolios more conservative.

Other providers cut fees or added new products last year. In September, Fidelity Investments added "bank-deposit portfolios"—FDIC-insured interest-bearing bank accounts—across five of its 529 savings plans. Last fall, Vanguard Group reduced fees across the plans it manages in Nevada, New York, Iowa and Missouri. In July, T. Rowe Price Group Inc. cut the plan-management and account fees in its Alaska and Maryland 529 plans.

Among the plans that earned Morningstar's top ratings: the Alaska and Maryland plans run by T. Rowe Price, Nevada's Vanguard 529 College Savings Plan, Ohio's CollegeAdvantage 529 Savings Plan and Virginia's broker-sold CollegeAmerica plan. Plans that got below-average marks include Georgia's Path2College 529 Plan, Nevada's Upromise College Fund 529 Plan and Wisconsin's Tomorrow's Scholar College Savings Plan. Rhode Island's CollegeBoundfund was the only plan to get Morningstar's lowest rating.

Even though 529 plans are making strides in addressing their flaws, families should consider spreading their bets, both in other investment vehicles and in different assets classes, say advisers. That will help them reduce the risk of relying too heavily on any one investment, and will build in more flexibility in case the money is needed for other purposes.

The good news: Thanks in part to the recent tax-rate extensions, there are plenty of other college-savings options worth considering, from standard brokerage and custodial accounts to Coverdell Education Savings Accounts and even Roth individual retirement accounts. The proper mix depends on individual circumstances, of course.

Where to Save

Wary of market volatility and in search of more flexibility, more families and advisers are expanding their college-savings repertoire. Here are some options to consider:

529 Savings Plans

Qualified distributions are taxfree, and many states offer tax deductions or credits for contributions.

Pros: Can result in big tax savings for families able to sock away substantial sums.
Cons: Some plans may have limited investment choices and charge high fees, and savers can face taxes and penalties if the funds are pulled out for other purposes.
Financial-Aid Impact: Minimal, if treated as parental asset.

529 Prepaid Plans

Families make an upfront payment in exchange for future tuition contracts or credits.

Pros: Prepaid plans aim to cover tuition no matter how much it increases.
Cons: Some states, facing budget woes and rising tuition, have had to close their plans to new participants, raise prices or impose fees.
Financial-Aid Impact: Minimal, if treated as parental asset.

Coverdell Education Savings Accounts

Offer tax-free growth for education expenses.

Pros: Cover a broad range of expenses, including college and K-12 expenses, while offering more investment choices.
Cons: Impose income restrictions and a low $2,000 contribution limit. Current tax benefits extended only for two years.
Financial-Aid Impact: Minimal, if treated as parental asset.

UGMA and UTMA Custodial Accounts

Accounts in which the parent acts as trustee. Offer some tax benefits where the first $950 of investment income is tax-free. Any income between $950 and $1,900 is taxed at the child's rate, and income above $1,900 is taxed at the parents' rate.

Pros: Can be used for most anything as long as the proceeds benefit the child.
Cons: Students gain control of the accounts when they come of age.
Financial-Aid Impact: Since the accounts are in the child's name, they are counted more heavily in financial-aid formulas.

Taxable Brokerage Accounts

Families can save for college in a standard taxable portfolio.

Pros: Investors have complete control over their investment decisions; accounts can be used for any purpose.
Cons: Investors are likely to face a tax bill on growth and withdrawals.
Financial-Aid Impact: Federal aid formulas count the value of the assets in the account (minus any margin loans) at the time the federal financial aid application is filled out.

Roth IRAs

Investors can generally withdraw their original contributions without taxes or penalties not only for college, but any reason.

Pros: Offers more flexibility and investment options.
Cons: If the parent is relying on the account for retirement, any withdrawals will chip away at the nest egg.
Financial-Aid Impact: Assets aren't counted in aid formulas, although withdrawals of a contribution are treated as income under aid formulas.

Savings Bonds

Interest earned on the Series EE or I bonds is free from taxes if used for qualified higher-education expenses.

Pros: Among the safest investments.
Cons: Currently, bonds pay a relatively low rate of return while the tax break is limited.
Financial-Aid Impact: Income from the bonds is considered income under aid formulas.

Sources: WSJ Research; FinAid.org

Here are some options to choose from:

• Coverdell accounts. The extension of the Bush-era tax rates maintains investors' ability to contribute up to $2,000 a year into these accounts. With Coverdells, investors can make tax-free withdrawals to pay for a broad range of educational expenses, from tuition for private elementary school and college to tutoring and computers. Investors can open them at a bank, brokerage or mutual-fund company, and the accounts offer a variety of investment choices.

There are drawbacks, of course. Individuals need to meet certain income thresholds to contribute—generally less than $110,000 for single taxpayers or $220,000 for married couples who file their tax returns jointly. Unlike many 529s, the plans don't allow investors to take a state tax deduction for contributions. And many big savers will chafe at the low contribution limits. Vanguard, concerned about changing tax laws, decided to stop offering Coverdells this year to new investors.

One option for families whose income exceeds those thresholds is to have grandparents, who may be in a lower tax bracket, open an account for the child.

• Savings accounts and bonds. Given the soaring costs of college, savings accounts aren't a good option over the long term. But many advisers suggest that families planning to tap their funds in the next year or two should pare back their stock-market exposure and transfer their money to more-conservative assets.

Despite rock-bottom interest rates, about 50% of parents saving for college say they now are using savings accounts or CDs, according to a recent Sallie Mae survey.

Over the longer term, investors want vehicles that can provide solid inflation-adjusted returns. They might be tempted by Treasury inflation-protected securities, or TIPS, whose principal and interest rate move in tandem with the Consumer Price Index. But many advisers frown on using them for college savings, in part because the returns aren't predictable. If prices fall and the U.S. economy enters a deflationary period, for example, investors can potentially lose money with TIPS.

Zero-coupon bonds, on the other hand, can be a good option for investors who time them to mature in the years that they need the cash for college, say advisers. Because the bonds don't pay interest during their life, investors can buy them at a deep discount from their face value.

• Brokerage accounts. Some advisers are forgoing 529 plans entirely in favor of regular brokerage accounts, which give investors more flexibility. If, for example, the child doesn't go to college or gets a full scholarship, the account owner generally can't pull the money out of a 529 for other purposes without paying taxes and a 10% penalty on the gains.

"There will be some taxes compared to the 529s, but the question is how much?" says Warren McIntyre, a financial adviser in Troy, Mich. "I would contend it's not a lot." An investor could construct a low-cost portfolio of exchange-traded funds, for example, that would likely generate few capital gains until they are sold, keeping taxes lower, he says. Investors could further reduce any taxes by offsetting any gains against investment losses elsewhere.

Families with young children should consider low-cost, growth-oriented ETFs, says Mr. McIntyre, such as a broad U.S. stock-market fund from Vanguard or BlackRock Inc.'s iShares, adding bond funds as the child grows older.

• Retirement accounts. For families who want to keep their options open, funding a Roth IRA can allow for more flexibility, advisers say. If the child gets a scholarship or decides not to go to college, the money can be used for retirement. What's more, retirement assets generally aren't included in financial-aid calculations. And since the contributions are funded with after-tax dollars, the original contributions can be withdrawn anytime without penalties or taxes to pay for college if needed.

For 2011, Roths can be opened by couples who file joint tax returns and make less than $179,000, and individuals who earn less than $122,000, though higher-income earners can convert existing IRAs to Roth accounts and take the tax hit now.

Another option: setting up a standard or Roth IRA in the child's name and having the parents deposit any income earned by the child—through a part-time job, say, or income earned through "household services" or a job in the family business—into the account, says Deborah Fox, a financial adviser in San Diego who specializes in college planning. "That money is eligible to be used for higher-education costs without penalties for early withdrawal," she says. (Ms. Fox now diversifies clients' college money across several 529 plans, custodial accounts and Roth IRAs.)

One downside: While retirement accounts are excluded from parents' assets in financial-aid formulas, distributions from IRAs may count as income, which can hurt financial-aid eligibility. That is in part why Gary Carpenter, a CPA specializing in college planning in Syracuse, N.Y., recommends that parents tap them after filing the last financial-aid forms in January of the child's junior year in college.

• Insurance plans. Heads up: Investors' search for safer savings vehicles has opened the door to advisers pitching more unconventional—and possibly costly—strategies based on insurance policies.

The brokers generally encourage parents to liquidate their 529 or other account or refinance their mortgage, and put the cash in a whole-life or universal policy. Among the touted benefits: The cash value of the policy is guaranteed and builds up over time. When it comes time to pay the tuition bills, the parents can take out a tax-free loan against the policy's cash value—while the loans and assets are shielded from financial-aid formulas.

Ms. Fox, the college-savings adviser, says she has seen a surge in such insurance college-funding pitches from clients asking her to review them. She discourages the strategy, as many of these contracts charge more than 3% a year in fees and generate hefty commissions for the adviser. The strategies often assume a rate of return that is tough to meet once the policy's expenses are taken into account, she says.

Even worse, investors are often required to lock up their money for long periods and could lose money if the insurer runs into trouble. And lawmakers could always change the rules on tax-free loans before it comes time to take out the money, leaving the holder in a bind.

• Borrowing. Given today's low interest rates, does it make sense to borrow to pay for school rather than spend down savings? One rule of thumb is to compare after-tax interest rates, says Mark Kantrowitz, publisher of FinAid.org, a financial-aid website. Taking money out of savings causes you to lose the return on investment. But if you would otherwise be paying more interest on a loan, you would be better off spending the savings.

In most cases today, it is generally cheaper to use savings, where one might be earning around 1% to 2%, than to take out a federal loan, where rates currently range from 4.5% on federally subsidized Stafford loans to 7.9% on Parent Plus loans, Mr. Kantrowitz says.

College Loan Data

Coverdell Accounts

Thanks to the recent tax deal, investors can continue to use Coverdell Education Savings Accounts for a broad range of expenses, such as college and K-12 tuition. Average account size: $11,079

529 Plans

Investors can withdraw earnings tax-free from 529 plans for qualified college expenses, but high fees and mixed performance have hurt many plans in recent years. What the average 529 investment option lost in 2008: 24%

Roth IRAs

Investors can withdraw their original contributions from Roth IRAs without penalties or taxes for any purpose—including college. Income limit to open an account, single filer: $122,000

Brokerage Accounts

Investing in a brokerage account typically results in a tax bill, but a lowcost, well-constructed portfolio may appeal to those looking for more flexibility and control. Percentage of money being saved for college in non-529 investments: 21%

Custodial Accounts

Known as UTMAs or UGMAs, custodial accounts can be used for anything that benefits the child. Limit after which income becomes taxed at the parents' rate: $1,900