529 offers low-risk investment options

01/12/2009

QUESTION:
Dear Joe,

I've been researching the rates of return on a lot of 529s and they're awful for the most part. Wouldn't I be better off investing in a high-yield money market account or similar?

-- Patricia

ANSWER:
Dear Patricia,
The market has been rough, not just to 529 plans, but to most retirement accounts and other investment pools as well. Picking the right investment strategy going forward depends on many factors, including the number of years before your children need the money for college and your own tolerance for risk.

If your primary goal is protection of principal combined with a reasonable rate of interest, you may be better off looking for that combination within a 529 plan rather turning to a taxable alternative.

Most 529 savings plans now offer money market funds, principal-guaranteed options and even bank certificates of deposit. Interest rates are competitive with similar investments available outside a 529 plan.

The big difference is taxes. The interest earned in a 529 plan is tax-free, provided the money is eventually used for qualifying college expenses. On the other hand, interest and dividends generated by taxable money market funds and similar accounts are subject to federal tax at rates as high as 35 percent.

If the taxable fund is paying dividends of 3 percent, and you are in the 25 percent federal bracket, your after-tax return is reduced to 2.25 percent.

And then there are the state income taxes, which can be another hefty tax drag, depending on where you live. With a 529 plan, not only do you avoid state income taxes on qualified distributions, but you may even be eligible for an upfront state income tax deduction on your contributions.

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