Key Questions About 529 Plans During the Pandemic

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. The COVID-19 crisis has thrown a wrench into college planning. Some students have changed their plans for fall, and many families have undergone a significant hit to their savings. Here with me today to discuss some key questions 529 college savings plan investors may have is Madeline Hume. Madeline is the lead author on Morningstar's latest 529 college savings plan Landscape Report.

Madeline, thank you for being here with us today.

Madeline Hume: Thank you for having me, Susan.

Dziubinski: Now, let's start with how far back has the market crisis set 529 plan investors?

Hume: Yeah, it's a good question. The answer to this question depends mostly on the age of the beneficiary. But we find that most investors choose to put their money into an age-based option, which means that the asset allocation shifts from a stock-heavy portfolio early in the beneficiary's life to a more conservative, bond-heavy portfolio as they approach the crucial years prior to college enrollment. So [we looked at] the average return of these portfolios in each age-based category over the past nine years through March 2020 to see how far the crash has set them back and estimate the number of years before an investor gets back to even.

Investors whose beneficiaries are at or nearing 18 are running out of time. On average, 18-year-olds need a 3.5% return to make them whole and not really much time left to achieve that. We're in May now, and they start enrolling in August and September. But near-college investors have reason to take heart. On average, markets have delivered returns in excess of 3.5% over the past nine years. So that's not a completely unrealistic goal to achieve in less than a year.

While portfolio's further out from college lost more than that amount of 19%, they have a good shot of recouping losses with the time that they have left. However, further economic shutdowns, additional market losses could set those individuals back.

Dziubinski: Madeline, should investors continue to be contributing to a 529 college savings plan if the beneficiary has decided to delay college?

Hume: If they're able, generally, yes. Our research finds that any year that investors do not contribute to their 529 account, they reduce the capacity for their savings to capture and compound investment returns. Since most savers in a 529 plan don't open an account until their beneficiary is around 7 years old, contributing for an extra year or two actually gets that investor closer to the 18-year time horizon than most age-based portfolios were designed for. So, to put it into context, for a $50,000 total savings balance, even one additional year can increase the ending account balance by up to $5,900.

Dziubinski: In addition to the additional compounding that you get if you continue to invest, what are the other benefits to continuing to invest in the 529 plan?

Hume: State income tax benefits are granted based on contributions rather than investment gains, which are what federal tax savings are based off of and have a big impact for investors who are choosing between staying put and continuing to put money into that piggy bank. But income tax benefits also vary pretty significantly from state to state, which makes it tricky to provide unilateral advice. So we researched whether it was possible to cover the average fee of a plan's age-based portfolios with the available state-specific tax benefits, and our research finds that as long as you continue contributing, more than half of the state's tax benefits cover direct-sold plans expenses for more than a decade during which time you're basically receiving free investment management. So there's no reason, really, not to stay invested.

Dziubinski: And then lastly, Madeline, what if the beneficiary decides not to attend college at all--of the 529? What happens to the money that's in that plan?

Hume: There are several ways for an accountholder to repurpose savings set aside in a 529 plan. Plans allow accountholders to change the beneficiary from one person to another. So if a former student has younger siblings, it can just be a matter of filling out the form. If that's not an option, there's also additional qualified withdrawals that aren't college tuition. Congress has increased the potential use for 529 plans in recent years. So 529 savings can be used to pay for apprenticeships and skilled trades, and they can also be used to pay off $10,000 of existing student loans, either for the intended beneficiary or for a sibling. So even if a child takes a nontraditional path toward education, those contributions do not have to be made in vain.

Dziubinski: Madeline, thank you so much for joining us today and sharing some of the insights from Morningstar's latest 529 plan college savings Landscape Report.

Hume: Thank you so much for having me, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar.com. Thanks for tuning in.