Getting Creative With 529 Plan Options

Note: This article is part of Morningstar's October 2013 College-Savings Boot Camp special report. This article originally appeared Sept. 10.

Question: I like the tax break I get for contributing to my state's 529 college-savings plan for my daughter and would prefer to use the age-based portfolio option, but I'm not thrilled with its allocation to stocks. Is there anything I can do?

Answer: Along with the state income tax deduction you mentioned, investing in a 529 plan typically offers college savers the chance to use age-based portfolios specifically designed for their time frames. These fund-based investment options adjust their allocation to stocks, bonds, and cash as the account beneficiary gets older, typically beginning at close to 100% equities and slowly tilting away from equities and toward bonds and cash as the beneficiary gets closer to college age. The rate at which this happens is often referred to as the age-based track's "glide path." (For a comparison of 529 age-based portfolio glide paths with those of target-date funds, see this article.)

Age-based portfolios are very popular with 529 savers because they offer "set-it-and-forget-it" convenience, with the plan automatically reallocating account assets each time the beneficiary reaches a given age, as opposed to the account owner having to babysit the money and making allocation and rebalancing decisions along the way.

Limited Age-Based Options in Some Plans
About half of 529 plans offer more than one age-based allocation track--for example, Utah's Gold-rated 529 plan offers aggressive, moderate, and conservative age-based portfolio tracks, with equity allocations for the youngest beneficiaries that range from 60% (conservative) to 100% (aggressive). By age 18, that allocation to equities ranges anywhere from 0% to 20% depending on the track.

But 529 plans offered by other states, such as Maryland and Oregon, offer just one age-based portfolio track. That would seem to put college savers who prefer to use these single-track plans, perhaps to qualify for a state income tax break, at the mercy of the plan administrators who designed them. However, there are ways that account holders who like the convenience of age-based portfolios, but not the particular allocations available through their respective 529 plans, to make tweaks by adding the plan's pure-equity, pure-bond, or pure-cash-equivalent portfolios to the account.

For example, let's say your state's only age-based portfolio track uses a 60% allocation to equities when the beneficiary reaches age 5, but you think that's too low and would prefer an 80% allocation. Assuming your plan also offers a 100% equity portfolio on its menu of investment options, you could strategically divert some assets (or add new ones) in the account to the 100% equity portfolio in order to achieve your desired allocation to stocks. Thus, if the account held $10,000 in assets and you wanted to achieve an 80% equity exposure using the 529 plan's investment options, you would keep $5,000 in the age-based portfolio while putting the other $5,000 in the 100% equity portfolio ((60% x $5,000) + (100% x $5,000) = $8,000, or an 80% equity exposure). Likewise, if you thought that the age-based portfolio's equity allocation was too high you could adjust the other way, diverting assets into a 100% fixed-income portfolio, assuming the plan offers one. Investors whose 529 plans offer just one age-based track but who would like to see other glide-path possibilities might look to another plan, such as Utah's, for ideas. (To see state-sponsored plan options for all 50 states, visit Morningstar.com's 529 Plan Center.)

Another option would be to avoid age-based portfolios entirely and build your own customized allocation using the plan's pure-equity, pure-bond, and/or pure-cash portfolios, ratcheting down exposure to stocks as the beneficiary gets older. 

This approach allows for more precision as far as allocation within your 529 account goes, but it also will require a bit more attention on your part than if you were to use solely an age-based portfolio. That's because an age-based portfolio that falls out of its target allocation rebalances automatically, whereas with a customized approach, you would be responsible for keeping on target the allocation you have in mind and making adjustments as needed.

A Way to Steer Clear of Bonds
The idea of customizing your 529 plan to meet your allocation needs also holds appeal for investors fearful that rising interest rates will lead to losses in the bond portions of their plans' age-based portfolios--a legitimate worry given that age-based portfolios typically hold 50% or more of assets in bonds as the beneficiary approaches age 18. In such cases account holders might consider creating their own customized allocations using the plan's 100% equity and 100% cash-equivalent options (which typically invest in very low-risk, short-term securities). For example, an investor who wanted a 50/50 equity/fixed-income split without any medium- or long-term bond exposure could simply put half of the account's assets in the pure-equity fund and the other half in the cash-equivalent account. Of course, such a plan would require regular monitoring of the account--especially the equity sleeve--to make sure the allocation doesn't fall out of whack.

One issue to keep in mind with any of these 529-customization strategies is whether the account charges annual fees per investment selection as opposed to a single fee for the whole account. For example, the Illinois Bright Start 529 charges an annual account fee for each index-based portfolio used. So using an index-based equity portfolio in addition to an index-based glide path portfolio within an account would mean paying $20 in annual fees compared with the $10 it would cost to use only one of the portfolios.

No one likes to pay extra fees, but for investors with substantial sums saved in a 529 and who seek greater control over the allocation of their investments, doing so may seem like a small price to pay.

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