According to a recent Bankrate poll, 52 percent of Americans have declined to invest in stocks or stock-based investments. But experts warn that without the strong capital gains that can be achieved from stocks, Americans may find it difficult to achieve future savings goals.
That could include parents with a limited window of time to save for their child’s college education. By choosing a stock-based fund within a 529 plan, parents can marry the tax-advantaged savings with the opportunity for growth. Parents can choose from a range of investments within a 529 plan, including bond funds and cash options, among others, with changes allowed once every 12 months.
But for parents who have younger children, especially, experts say that constructing a portfolio that is skewed toward stocks may be the more lucrative choice.
[Learn why you should look beyond performance when investing in a 529 plan.]
1. Stocks provide opportunity for growth. It’s no secret that the cost of college continues to increase rapidly every year, so parents investing in a 529 with hopes that the account’s growth will help bridge any gaps between cash savings and total college costs may want to take an aggressive approach. Parents can’t choose individual stocks in a 529 plan, but they do have the option to invest more heavily in stock-based funds.
There is always some risk involved with stocks, but if parents have the time to ride the waves of the market, stocks offer a larger opportunity for growth because they have the ability to appreciate in value. Bonds earn only the interest yield that is calculated from the principal base — the principal itself cannot increase in value.
“Current estimates have college expenses increasing at 5 to 6 percent per year,” says Kevin Gahagan, a certified financial planner with Mosaic Financial Partners in San Francisco. “In this environment, generating real growth at or above this inflation rate is essential.”
According to David Rae, a certified financial planner and vice president of client services for Trilogy Financial Services in Los Angeles, parents can expect a return of 8 to 10 percent on an average stock fund, versus around 4 to 6 percent for bonds. Those estimates are based on investments of at least five years, though Rae says that the more mature the investment, the closer the returns will be to those averages.
The key to savings success is knowing when to get in and when to get out of stock investments, says Mark Kantrowitz, senior vice president and publisher of Edvisors.com, a website offering financial aid advice for students and their families.
“The stock market is going to decrease at least 10 percent two, three or more times during any 17-year period,” he says. “So the trick to investing in a 529 plan is to manage the risk. When the child is young and less has been saved, the family can afford to take more risks than when college is just around the corner.”
As the time when families will need to use the money draws nearer — typically, once the child enters high school — the investment mix of the account should shift in favor of bonds. For parents looking for a “set it and forget it” approach, there are age-based fund options that will automatically make the transition from more stocks to bonds as the child nears college age. Obviously, the earning potential, as well as the appreciation, of the account will diminish considerably, but so will the risk of loss.
[Discover three ways to make the most of a late start on college savings.]
2. Stocks provide dividends. When every dollar saved for college counts — and they typically do — parents need all the help they can get to increase the value of their 529s. With stocks, parents can receive additional income on top of growth via dividends, which are payments companies make to their shareholders based on stock performance that can be in the form of cash or additional stock shares.
“Over the past few years, you would have earned around 2 percent off dividends alone if you had invested in an S&P 500 [stock] fund in a 529,” says Rae.
3. Stocks aren’t the only risky investment. While bonds typically seem like a safer investment when compared to stocks — and bonds are, overall, less volatile than stocks — they still fail to provide a guarantee against loss. In fact, when interest rates go up, bonds can actually decline in value, while stocks can continue to increase.
“Let’s say I purchased a 10-year bond at 2 percent yield, then interest rates rise, so newly issued 10-year bonds are paying 3 percent,” Gahagan says. “When you try to sell the bond to get cash, those higher rates impact the value you can get on it because no one will pay you face value for an instrument that’s not going to give them market rates.”
[Bust five myths about 529 plan bonds.]
The result, he says, is that the price of the bond must be lowered — making it worth less than the amount originally invested — so that the discount the buyer gets on the purchase of the bond, plus the 2 percent yield, equals the 3 percent available in the open market.
“And the more interest rates rise, the deeper the discount you see,” Gahagan says.
That can be devastating for parents whose entire 529 portfolios are bond-based. There are no guarantees on stock performance in a higher interest rate economy, but, unlike bonds, their value is not directly related to interest rates.
Because of the continuing upturn in the economy and what experts call an “inevitable” return to higher interest rates, Gahagan and others continue to recommend a 529 investment mix that includes a significant portion of stocks — at least in the beginning.
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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3 Important Facts About Stocks Within College Savings Plans originally appeared on usnews.com
