When you're filling out the application to open your 529 account, one of the biggest questions you'll have to answer is how to invest the money. Originally, 529 plans were designed to be easy investments to manage. Most plans offered a very limited selection of mutual fund investment options, and most allowed for changes in those options only once a year. In short, they were designed with the thought of "buy-and-forget."
Today, you'll commonly find three distinct types of investment options in 529 college savings accounts:
- Individual mutual funds: For instance, you might find the Vanguard Index 500 Fund (investing in the stocks of large US companies) or maybe a bond fund like the PIMCO Total Return Fund. The advantage here is that you have complete control over how you are investing. The downside is that you must already know how to design an investment portfolio. This means you need to (a) understand what the fund names mean, (b) select the funds that are appropriate for you, and (c) determine how much to invest in each fund. The individual mutual fund option is way too complicated for the average 529 accountholder.
- Funds-of-funds: A "fund of funds" is an investment option where you invest all of your account balance into one mutual fund, and the managers at that fund invest in other funds. The managers assume the three investment decisions I outlined above, and they use their professional judgment to pick the individual mutual funds that will ultimately hold your money. A fund-of-funds is a good option if you want to simplify your 529 investments. The disadvantage here is that (a) there may be an added layer of cost for this arrangement (the best plans do not charge extra for funds-of-funds) and (b) you still need to have some idea about how much risk you can tolerate. Why? Because funds-of-funds usually come in multiple flavors, including "moderate", "aggressive" and "moderately aggressive."
- Years-To-College: If you don't know how much risk you can tolerate (or should tolerate) and you don't feel the need to have a great deal of control over your 529 investments, choose the years-to-college option. The years-to-college option is like the fund-of-funds approach but the investments in the account, and the risk level, are based on the number of years until your child enters college.
For instance, if there are 18 years until college, most 529 plans using the years-to-college strategy will invest your money so that most of it - 75% or more - is in a diversified mix of stocks (usually large companies, small companies, and international companies) with the balance invested in a diversified mix of bonds.
As the time for college draws near, the managers of your years-to-college option will slowly shift the mix of investments (the "asset allocation") out of stocks and into bonds and money market funds. This shift reduces the risk of loss in your college savings account as you approach the time when the money will be needed.
Some people wonder if the years-to-college option is the right way to go.
They question whether or not it makes sense to shift the asset allocation toward more conservative investments over time. These people often prefer to be aggressively invested, right up until the very last minute. They're concerned that they might miss out on some upside move in the stock markets.
So why wouldn't you want to invest in the years-to-college option?
I can think of a few reasons:
- You have money saved for college outside your 529 account, and that money is invested either very aggressively or very conservatively, in which case you might want to control the investments in your 529.
- Your 529 college savings money is actually intended for more than one child, where some are older than others.
- You don't want to bear all the risk that comes with the years-to-college option.
This last point is crucial. The years-to-college option is front-loaded with exposure to stock market risk, so it might not be right for certain physician families.
I know from experience that physicians really, really want to make sure their kids have the best shot at a solid education. And I know from experience that it makes mothers and fathers nervous to think that the stock market might crater just about the time their tuition bill is coming due.
No matter how you invest for college, make sure the strategy you choose matches your need for return and ability to tolerate risk.