529 Plan Investing for High Net Worth Investors

By Paul Jacobs and Laurie Samay Jun 20, 2014, 6:09 PM 

Section 529 plans have grown into one of the most common ways to save for college. While the decision to establish a 529 plan account is often simple, managing the assets over time can be much more complicated.

The rising costs of higher education, which have outpaced inflation consistently in recent years, have raised the stakes. With more than $200 billion invested in 529 plans, savers are clearly looking to 529 accounts as a way to keep up with rising costs. Section 529 accounts can be used as a tax-free vehicle for college saving, and contributions may be deductible, depending on your state of residence. Qualified expenses for 529 account distributions include tuition, fees, books, supplies and equipment required for a beneficiary’s enrollment or attendance at an eligible educational institution.

Withdrawals from 529 plan accounts for nonqualified expenses are allowed, but at a price. They are subject not only to federal and state income tax, but also to an additional 10 percent federal penalty tax on investment earnings. This penalty tax does not apply to nonqualified withdrawals resulting from a beneficiary’s death, disability, scholarship (up to the amount of the scholarship) or attendance at a military academy.

There are two types of 529 plans: prepaid tuition plans and college savings plans. This article focuses on the latter. Prepaid tuition plans are guaranteed by the state governments that offer them, and allow investors to lock in future tuition rates at in-state public colleges at current prices. These plans do not involve the same sort of investment decisions for the account owner and, in our opinion, are generally riskier because of their reliance on states’ ability and inclination to meet their financial promises. In contrast, college savings plans offer menus of investment options and allow for account assets to be traded once per calendar year.

The main goal of some 529 investors is simply to try to save enough to contribute toward the beneficiary’s college tuition, assuming that the remainder will come from other sources such as financial aid, scholarships, gifts and loans. But high net worth individuals with the means to pay full tuition regardless of the market environment will have different decisions to consider about the account’s asset allocation and the optimal changes to that allocation over time, or its “glide path.”

A glide path is a plan for gradual shifts in an account’s asset allocation as a target date approaches. For 529 plan accounts, this is very often the time at which the beneficiary reaches college age. The beneficiary’s age should serve as the foundation for the 529 plan’s investment strategy. Investors can seek higher returns when the beneficiary is young and college costs are still relatively far in the future, so that risks are more easily borne. As the beneficiary ages and the liability becomes more immediate, investors should focus on preserving principal, which will necessarily limit growth.

There are no solid rules about how to choose the best 529 plan asset allocation, let alone the best glide path. While many plans have standardized glide paths, these paths offer no guarantees, and the results can diverge significantly, depending on which plan you select. In September 2012, The Wall Street Journal published an article describing the wide variance in investment strategies and returns among different plans, as well as certain 529 plans’ most and least aggressive glide paths. Customization will always offer a better fit for your personal situation and goals.

While no strategy will be right for everyone, the first step for creating a customized 529 glide path is to consider an appropriate starting point. For our clients, we recommend a baseline approach of maintaining a 100 percent equity allocation in the account at first, typically until the beneficiary is 12 years old. Thereafter, 10 percent of the allocation can be moved to a more conservative option each year. This will result in a 100 percent conservative allocation by the beneficiary’s final year of a four-year program, assuming that he or she goes directly from high school to college.

For some investors, this baseline approach may need to be customized further. For example, it may be appropriate for some investors to maintain a 100 percent equity allocation longer or to begin shifting funds to more conservative investments earlier. Some factors to consider when developing your personal 529 plan investment strategy are:

Risk Tolerance. Some investors are willing to take on more risk than others, even among those with equal ability to do so. It is important to realistically assess your tolerance for risk, both for your overall portfolio and for your 529 plan account.

Additional Sources Of College Funding. If you are able to meet college costs from other sources, such as your personal taxable accounts, a riskier 529 strategy may be more palatable to you. In addition, you may expect the beneficiary to receive outside college funding, such as scholarships, financial aid or gifts from other family members. In this case, you may be willing to take on more risk in the account.

Graduate School. If the beneficiary intends to attend graduate school, you may not want to shift to a fully conservative asset allocation as soon as you otherwise would. It may be appropriate to maintain a more aggressive allocation until a few years before the beneficiary intends to enroll in graduate school.

Expected Cost Of College. If the beneficiary seems likely to attend a lower-cost public or in-state school, you may want to take on less risk in the account. Conversely, if the beneficiary has his or her heart set on an expensive private institution, taking on more risk might make sense.

Number Of College-Bound Children Or Grandchildren In The Family. A 529 plan account with excess funds after a beneficiary graduates can be rolled over to another beneficiary within the family. As a result, you may consider taking on more risk in an older child’s account. If the markets underperform, you can supplement the older child’s account using a younger child’s account, with the intention of recouping any losses using the younger child’s account with a longer time horizon.

Note that this list is not exhaustive, but rather illustrates some of the most common factors that may cause investors to deviate from our baseline recommendations. At Palisades Hudson, we customize this decision based on each client’s situation and needs, and we revisit the strategy over time.

Section 529 plans have become a staple of saving for educational expenses. For high net worth investors, they can prove an extremely valuable piece of an overall financial plan. Paying for college can be stressful, but by customizing your 529 account’s asset allocation and glide path, you can rest assured that you will avoid taking on unnecessary investment risk while paying for college on a tax-advantaged basis.

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