COLLEGE SAVINGS 101

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TIPS for your 529 plan
by Joe Hurley, founder, Savingforcollege.com
Tuesday, March 27th 2007

Treasury Inflation-Protection Securities (TIPS) are showing up in an increasing number of 529 plans—with good reason. By guaranteeing a return above the general inflation rate, TIPS provide at least some measure of protection against rising tuition costs. Such protection is the primary goal of many college savers.

A TIPS is a U.S. Treasury note with a set maturity date that pays a fixed rate of interest. But it differs from other Treasury notes in that the principal of the note adjusts every six months based on increases (and decreases) in the Consumer Price Index (CPI). Not only does the principal value of the TIPS keep pace with general inflation, but the semi-annual interest payments also increase over time as the note's fixed rate is applied to the adjusted principal.

You can buy TIPS on your own either directly from the Treasury or through a broker. You'll also discover about a dozen of the larger fund families offering TIPS mutual funds. The interest earnings on TIPS held in your own portfolio are exempt from state taxes but are taxable on your federal return. Many individuals decide to stay away from TIPS because, unlike the tax-deferred interest on U.S. savings bonds, all TIPS earnings (even the inflation adjustments) must be reported each year.

A 529 plan solves the tax problem, because the earnings in a 529 plan are not only tax-deferred, but are tax-exempt when distributed in the year the beneficiary incurs qualified higher education expenses. This makes a 529 plan an ideal vehicle for owning these investments, assuming of course that the account is ultimately used for college.

Because tuition has a history of increasing faster than the CPI, TIPS may not keep up with college costs. They will do so only if the fixed rate of interest (as adjusted by any premium or discount on the purchase) is at least equivalent to the difference between college cost inflation and general inflation. For example, the 10-year TIPS due January 15, 2017 pays interest of 2.375% and currently trades at about 101.2% of face value, to yield 2.18%. If you purchased that note today, and did not have to pay any income tax on the earnings, your investment would keep pace with any college where college costs increase at a rate no more than 2.18 percentage points above the CPI.

Data from the College Board's Trends in College Pricing 2006 suggests TIPS may do fairly well in protecting against private college tuition increases but not so well with public university tuition. The average annual increase in tuition and mandatory fees at private colleges over the past five years has been 2.2 percentage points above the CPI, while at public universities the average increase has been 6.2 percentage points above the CPI.

Listed below are all the 529 plans we've found offering a TIPS investment option. In addition to these programs there are a number of 529 plans utilizing TIPS as a component of their fixed-income options. (These include many of the programs managed by TIAA-CREF and Upromise as well as 529 plans from the states of Kansas, Montana, North Carolina, Rhode Island, and West Virginia.)

Before committing your 529 dollars to TIPS options, you should be aware that, like other bonds, TIPS will fluctuate in value based on the movement of interest rates and inflation. Morningstar shows that the average return of TIPS funds for all of 2006 was only 0.1%, but in 2007 the funds have already returned 2.3% on average. Also note that other inflation-indexed options exist in the 529 world, including state-sponsored prepaid tuition plans, the private-college Independent 529 Plan, and the CollegeSure® CD offered through the Arizona and Montana 529 plans.

529 Plans offering a TIPS investment option:

Indiana CollegeChoice 529 (adviser-sold)
Iowa Advisor 529 (adviser-sold)
Missouri MOST (direct-sold)
Nevada Vanguard 529 (direct-sold)
New Hampshire Fidelity Advisor 529 (adviser-sold)
New York 529 Direct (direct-sold)
Ohio CollegeAdvantage 529 (direct-sold)
Pennsylvania 529 Direct (direct-sold)
South Dakota CollegeAccess 529 (direct- and adviser-sold)
Virginia VEST (direct-sold)
West Virginia Director SMART529 (adviser-sold)

» Claiming a state income tax deduction - 12/20/16
» Understanding 529 Investment Options - 12/13/16
» Should you open an UGMA/UTMA 529? - 02/06/08
» Understanding your state's slice of 529 fees - 12/13/07
» Planning for the new "kiddie tax" - 10/30/07
» Show All Archives

 

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