Look After Investments In 529 Plans

If you're a parent or a college student and you're worried about the escalating cost of a higher education, you've probably wondered how to pay for what could be the second most expensive purchase in your life after your home.

One new parent asked me this recently: "Is it a good time to start a college fund? Our daughter is only 1, but we haven't put any money away for her. Should we just put some in a regular savings account versus a 529 plan?"

I know the inclination is to flee to the safety of a savings account for your cash. Despite the tumultuous stock market, I still believe that a 529 college-savings plan is a good long-term strategy.

But if you are going to invest in a 529 plan, make sure you don't just set it and forget it like you would a chicken in a rotisserie oven.

In fact, in its sixth annual survey of the best and worst 529 college-savings plans, Morningstar, an independent investment research firm, criticized several plans for maintaining too-aggressive asset allocations for students nearing or already in college. Morningstar also smacked some plans for sticking too long with floundering investment options.

The annual study of 529 plans focuses on several areas: the underlying funds, expenses, diversification, asset allocation and flexibility.

"Unfortunately, the past year hasn't been so rosy in the college savings universe," said Greg Brown, a Morningstar mutual fund analyst and the author of the 529 study. "The terrible performance of some 529 plans in 2008 clearly illustrates that, now more than ever, investors can't afford to invest in anything but best-of-breed college savings plans."

There are two types of 529 plans: prepaid tuition plans and savings plans. A prepaid plan allows you to pay for tuition in advance. The more popular savings plan allows you to invest in a tax-deferred investment account. Money withdrawn from a 529 investment account is free from federal tax (and in most cases free from state and local taxes as well) when used for qualifying college costs. Additionally, many states offer tax deductions for residents who make contributions to a 529 plan.

Although the 529 plans are state-sponsored, you can invest in any plan regardless of where you live. And money invested in a 529 plan can be used for a state or private institution. Every state and the District of Columbia offers at least one 529 plan.

Morningstar's report reinforced that you have to not just be mindful when you select a 529 plan, but that you also need to keep track of the plan's performance, fees and investment options. The research company was particularly critical of plans that didn't adjust their age-based portfolios to decrease market risk. With an age-based option, the idea is to create a portfolio that aggressively invests in equities when your child is young. It then pulls back and becomes more conservative -- investing in bonds and cash, for example -- as he or she gets closer to attending college.

"There's not a strong consensus on the exact amount of stocks, bonds and cash to hold for a particular time horizon, but it's clear to us that some plans didn't move out of equities fast enough and were courting far too much risk, given that they were geared toward students getting close to matriculation," Brown wrote. "After all, most students deplete their 529 assets in the space of four years, leaving little time to recover from a serious market downturn like 2008's."

Although Utah Educational Savings Plan Trust earned a spot on Morningstar's best list, one of its age-based options was singled out for being "dangerously bold" in investing 65 percent of assets in equities for a college-enrolled beneficiary.