Colleges face an uncertain future as the coronavirus disrupts U.S. higher education. How should parents, especially those with younger children, set money aside for college costs when things are so unpredictable?
The go-to college savings vehicle for wealthier families has long been the tax-advantaged 529 plan offered by many states. Contributions made to 529 accounts are eligible for deductions or credits against state income taxes. Earnings in the accounts grow tax-free and withdrawals don't trigger taxes as long as they're used for certain educational expenses.
Higher education may change, but there will still be bills to pay. That’s why most college finance experts I spoke to agreed that for many high earners, making at least some contribution to a 529 plan will continue to make sense.
Recent modifications have made 529s more flexible and more attractive in an unpredictable world. Money in the funds can now be used for trade schools or vocational programs, and a portion can be used for K-12 education or to pay off student loans.
The familiar advantages of 529s will continue to apply. If structured properly, they tend to trigger fewer restrictions on financial aid than other types of savings accounts. An exception to the annual $15,000 federal gift limit makes them well suited to big gifts from generous grandparents — the Internal Revenue Service allows front-loading five years of gifts, or $75,000, into a single 529 contribution. And if the intended recipient decides against going to college, another child or qualified family member can tap the funds instead.
Coronavirus-induced investment losses have made some parents worry that their 529 plans will come up short just as they’re on the hook to pay for their kids' tuitions, but these concerns seem to be overblown, according to data from Morningstar. Their research shows that given the annual returns for most portfolios over the nine years ending in December 2019, it's reasonable to think that most 529s will be able to recoup losses from the market downturn in the first quarter of 2020, even for those nearing college.
Still, it’s important in such an unpredictable market environment for investors to stick with funds that shift to more conservative allocations as their children approach 18.
It's also prudent to minimize fees by choosing plans that are sold directly to investors rather than through advisers. And if you expect the cost of college to start coming down, don't overfund your 529.
And it’s still a good idea to open a 529 when your child is small. Many performance models assume that investors start funding the plans at birth, but most people open the accounts when their child is seven, says Morningstar's Madeline Hume.
For some savers, other types of accounts may be a better fit than the 529s. If you're unsure your child (or children) will be attending college and don't want to get hit with the penalties for withdrawing money for non-educational expenses, or if you have a short investing time horizon, or if you want more investment options than the funds offered by 529 plans, there are other options.