Monthly top tips

So Says the 529 Guru

No. 7
Joe Hurley
Monday, May 12th 2003

We all want our college savings to grow, so Ive picked a couple of questions that touch on that topic. Im also very pleased to announce that you will find a new look and new tools when you return from the Memorial Day holiday at (The site will be down for a couple of days over that weekend.) Let us know what you think!

Question: I have a 3-month-old, and I think I want to start a 529 account for him. I say "I think" because I've been researching this on and off for about 6 months, but now with the volatile market, I'm wondering if I should wait. Or maybe I should just start one and invest in a very conservative portfolio as opposed to an age-based one that would start very aggressive. Do you have any suggestions? - Ken

Answer: With a child at least 18 years away from college, most investment professionals recommend that your portfolio be heavily weighted towards stocks in order to have the best chance of keeping up with tuition inflation. Thats why the age-based portfolios in 529 plans are more aggressively invested for young beneficiaries. (Its difficult to convince some investors of the wisdom of such a strategy since just about every age-based account opened for a young child in the last three years has declined in value. Research at shows the age-based portfolios for the youngest age groups suffered a loss of 17.67% on average during 2002. Age-based accounts for the oldest age groups averaged a loss of only 0.30%.)

In your case, dollar-cost averaging can reduce the risk of a volatile market. Instead of making a single large contribution to a stock-weighted portfolio, you make contributions in smaller chunks over time, retaining the extra funds temporarily in a money-market fund or other conservative investment. If the market suffers another downturn, you would be acquiring a portion of your shares at the lower price. (If the market sustains a rally, on the other hand, you will be missing out on some of the upside.)

The easiest way to use dollar-cost averaging with a 529 plan is simply to enroll in the programs automatic contribution option. Either monthly or on some other scheduled basis, funds will be electronically transferred from your bank account into your 529 account. Most 529 plans accept automatic contributions with very low minimum-contribution requirements. Automatic contributions via payroll deduction may be another option, depending on the particular 529 plan and your employers payroll procedures.

Lets say you want to use dollar-cost averaging but prefer to make a single lump-sum contribution into the 529 plan. Until recently, you had only two ways to do that. One was to reallocate among the programs investment options one time per calendar year as permitted by the IRS. The other was to establish two accounts, one that names yourself as beneficiary and invests conservatively, and the other that names your child as beneficiary and uses a more aggressive age-based or static option. As often as desired, you could request a rollover from the conservative account to the aggressive account. The rollovers qualify as tax-free since the beneficiaries (you and your child) are members of the same family. But these strategies are cumbersome, may not be particularly effective, and could be costly if the 529 plan charges a fee for rollovers.

Recently, some 529 plans have begun to offer their own dollar-cost averaging option that simplifies the process. Your lump-sum contribution is made to the programs money-market or guaranteed investment portfolio, and a portion of it is automatically transferred to a different investment portfolio every month or on some other set schedule. Presumably, the 529 plans offering a dollar-cost averaging option have received assurances from the IRS or legal counsel that it does not violate the one-time-per-year investment-change restriction.

Question: With the latest dip in interest rates, I am planning to refinance my mortgage (currently at 6% for 25 years). I have been toying with the idea of doing a cash-out and putting the lump sum into my states (Pennsylvania) prepaid program before its annual price hike. A 5.25% 20-year mortgage is available, which is what I was considering. Our boy will be nine this summer. I would appreciate any thoughts on this approach. - Michael on the Message Board

Answer: Borrowing against the equity in your home and putting the proceeds into your states prepaid tuition plan may look like a smart thing to do, especially if todays double-digit tuition hikes at many state schools continue into the future. Generally speaking, if the value of your 529 prepaid tuition contract increases at a rate in excess of the interest rate on your mortgage, you end up ahead. It becomes even more attractive if the interest on your mortgage is tax-deductible and the earnings on your 529 contract are tax-free.

However, there are a few caveats that you need to consider before jumping at this opportunity:

- Home mortgage loans must be paid monthly, but you cant withdraw money from the 529 plan for this purpose without incurring tax and penalty. Make sure your cash flow will handle the higher monthly payments.

- Consider all borrowing costs when borrowing on the equity in your home. Closing costs can be substantial. Also, check to see if the prepaid plan is charging a premium over current tuition levels (Pennsylvania currently is not). A premium can reduce your overall return to an amount less than the annual tuition increase.

- The payout from the prepaid tuition plan may not in fact be tax-free, even when used for qualifying college costs. The tax exclusion is scheduled to expire at the end of 2010, and your son may be subject to federal income tax on earnings withdrawn in 2011 and later years (Im hoping Congress will make the exclusion permanent).

- There are some restrictions on the amount of home mortgage debt that can be considered when calculating deductible interest, so check with your tax accountant to be sure the interest on the mortgage is fully deductible. In addition, interest on home-equity indebtedness taken to fund a 529 plan is not deductible against the alternative minimum tax. Your cash-out amount may be classified as home-equity indebtedness.

- Your strategy may negatively impact your childs eligibility for financial aid in the future. Home equity currently does not count against the student in the federal aid formula, but 529 plan assets do. Prepaid tuition plans are particularly nasty in this regard: their benefits reduce eligibility dollar-for-dollar. Pennsylvanias old prepaid plan has been turned into a guaranteed savings plan, so the impact in your particular case should be much less. Your account is treated as a parental asset, with no more than 6% of its value counted as an asset. However, Congress is considering some changes to the financial aid formulas, so it is impossible to predict the status of 529 plans at the time your child will be entering college.

- Realize that prepaid tuition plan administrators face the same struggle as parents do in handling tuition hikes. If the program finds itself unable to afford the increases, it may have to take corrective measures in the future that could affect your investment.

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