Saving for a child’s college education can be an emotional journey for parents and grandparents. But, making emotional investment decisions with your college savings can have negative consequences that prevent you from reaching your goals.
Overestimating tolerance for risk
Many 529 plan portfolios offer varying levels of risk, such as conservative, moderate or aggressive. Investors who select aggressive portfolios are willing to take on a higher level of risk to maximize returns, and those who select conservative portfolios focus more on preserving capital.
However, many investors overestimate their risk tolerance when selecting investments. For example, a parent may be comfortable with a 15% return gained during a bull market, but will they be able to stomach the loss when markets turn around?
How to avoid it: When determining your risk tolerance for 529 plan investments, try to consider a worst-case scenario. What is the maximum amount you feel comfortable losing in your portfolio during a given time period?
If you prefer a hands-off approach to managing risk in your 529 plan portfolio, consider an age-based investment option. With an age-based investment option, the investment manager manages risk by shifting the asset allocation toward more conservative investments as the beneficiary gets closer to college.
Not taking enough risk
Some families are overly cautious with 529 plan investments. Being too risk-averse prevents you from investing aggressively enough to yield sufficient gains to keep up with inflation, let alone any appreciation.
How to avoid it: Consider investing your 529 plan portfolio in at least 80% stocks for the first 5-10 years of your child’s life, before switching to an age-based asset allocation. This strategy improves return on investment without having much of an impact on risk, since less money is at risk during the first few years of the 529 plan investment.
Having a negative perspective
Many 529 plan investors feel confident when markets are up but fear the worst during a market downturn. Yet dollar-cost averaging yields the same results, regardless of whether the markets are up or down. The average price per share over time represents the high and low prices experienced over the life of the 529 plan account.
How to avoid it: Schedule automatic 529 plan contributions. Parents who invest a fixed dollar amount at pre-determined intervals gain the benefit of dollar-cost averaging. When markets are down, dollar-cost averaging takes advantage of the discounted price and purchases more shares per dollar.
Reacting on impulse
Investors often panic during a market decline, especially after a long bull market. But, parents who pull their money out of a poor-performing 529 plan will lock in their losses and miss out on the market recovery.
How to avoid it: Work with a financial advisor. A financial advisor can keep a family from making emotional decisions such as pulling out of 529 plan investments at the first sign of volatility. Parents have the option to invest in one of the 30 available advisor-sold 529 plans or consult with a fee-only financial planner on how to manage investments in a direct-sold 529 plan.
Believing the headlines
With recent news coverage of “free” college tuition and student loan debt forgiveness, some parents may wonder if it’s even worth saving for college in a 529 plan. These stories make exciting headlines, but they only apply to a small percentage of students. Free college tuition programs are only available in certain states and are often limited to two-year colleges. Student loan forgiveness is generally only offered to college graduates who work in certain professions or who meet other requirements.
How to avoid it: Continue saving toward your goal. If you end up saving too much for college, you can always take a non-qualified distribution from your 529 plan. The earnings portion of a non-qualified distribution will incur income tax and a 10% penalty, but the financial impact is generally no worse than if the investor saved in a taxable account.
Keeping up with the Joneses
Some parents feel obligated to send their child to a prestigious college, even if they can’t afford it. Student loans can put an expensive college within reach, but students may not fully understand the consequences of borrowing.
How to avoid it: Review your 529 plan and determine how much you can potentially save by the time your child is ready for college. Aim to save 1/3 of projected college costs and plan to cover 1/3 with current income and 1/3 with student loans. If the total student loan debt is less than your child’s expected starting salary, they can reasonably expect to repay the debt within 10 years. Discuss college prices with your child and make decisions based on what you can really afford.