How to Invest a 529 Account
Money in hand, you’re looking to open a 529 for a child, grandchild, or other family member who you love and have high hopes for.
But the huge variety of options and details might give you pause. Even if you already know which state’s plan you’d like to utilize, you may face a number of choices for how to invest the account.
Making sense of the options
Generally speaking, there are three ways to invest your 529 savings:1
- Choose an age-based portfolio
- Choose a risk-based portfolio
- Allocate across your own selection of mutual funds
There are pros and cons to each, hinging on time, money, and the ability to invest through difficult markets.
Age-based portfolios (target-date funds)
In many 529 plans, the default investment plan involves a pre-allocated portfolio based on the beneficiary’s age. As the child gets closer to college, the portfolio is rebalanced to become more conservative, generally reducing equity allocations in favor of bonds.
Age-based portfolios are very similar to the target-date funds that you might have seen in your 401(k). Just like target-date funds, these portfolios are very convenient and you do not need to actively manage them.
However, age-based portfolios do have drawbacks.
- Investment costs can be higher than a self-directed portfolio, depending on the mutual funds chosen.
- Trading fees can also be higher: These funds also rebalance more often than you might choose to, which triggers fees and expenses that are passed back to you.
- Risk levels may be higher or lower than you want: The actual allocation in the account at any given time will depend on your specific provider — in other words, the definition of “conservative” and “aggressive” varies (sometimes widely) from one plan to another.
Similar to an age-based fund, a risk-based fund will allocate to a portfolio of mutual funds based on your stated risk tolerance. With this account, however, the portfolio will stay true to that risk tolerance level, instead of becoming more conservative over time.
This can be useful if you have a very strong investment philosophy or if you prefer to be the one to decide whether to change the risk profile of your account.
The main drawback, besides the potential for higher costs, is that your preferences might not always align with your goals.
For example, a conservative investor seeking growth needs to decide whether to be conservative or to take a higher-growth strategy — the two are almost mutually exclusive! Similarly, a highly risk-tolerant investor may need to reconsider the implications of losing a great deal of principle right before college starts.
Finally, a self-directed portfolio means just that: you choose each individual mutual fund in the portfolio and manage the allocation over time.
This can work very well if you like to spend time on your investments on a regular basis and if you can manage market turmoil without losing sight of your long-term strategy.
Part of directing your own portfolio is doing your own rebalancing. Rebalancing is a way of managing risk by keeping your actual portfolio in line with your strategic asset allocation.
For example, if you start with 60% of your portfolio in stocks and they grow rapidly, the proportion of your portfolio in stocks could soon grow to, say, 70%. At that point, you’ll be working with a completely different asset allocation and risk level. To maintain your original strategy, you’d need to sell off some of your equity allocation and invest more in your other chosen asset classes.
On the subject of trading: if you manage your own 529, it’s very important to remain disciplined. Over-trading is an easy way to rack up expenses, which eats away at long-term performance.
If you find that you struggle to stick with your strategy when the market falls, a self-directed 529 might not be the best solution for you.
For any account
Whatever plan you choose, there are a few key elements you should keep in mind:
First, be sure that the plan you’re choosing balances cost with your personal needs. While cost is important — after all, any fees you pay are reducing returns and can’t be reinvested — the lowest sticker price isn’t necessarily the lowest cost option.
For example, if you manage your own portfolio of cheap index funds but trade anytime the market dips south, you could end up spending more money than someone who buys a nominally more expensive age-based fund.
Second, check whether your state plan offers a state income tax deduction. Not all of them do, but it could save you a significant amount of money down the line.
Plans also differ widely in their investment options and pricing, so it’s a good idea to shop around for the one that will offer the greatest benefits to you. Balancing the benefits and the costs of each plan will help ensure that you’re giving your 529 — and the loved one benefiting from it — the best possible chance at long-term growth and a well-financed college education.