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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The pandemic has thrown a wrench in traditional college planning. Some students are deferring college, others are engaged in remote learning, and still others are pursuing lower-cost options like community colleges, and many are questioning the price-value proposition of higher education. Joining me today to discuss some key questions that 529 college savings plan investors may have in light of all this is Madeline Hume. Madeline is an analyst with Morningstar's Manager Research group on the multi-asset funds team.
Madeline, thanks for being here today.
Madeline Hume: Thank you for having me, Susan.
Dziubinski: Now, let's start off by talking a little bit about how 529 college savings plans have done this year, first through that bear market that we experienced in the second quarter, and then how they've done during the recovery since then.
Hume: Absolutely. Everybody's experience this year has been a little bit different, both personally and as far as investing goes. So, it really varies depending on what the saver is invested in and the age of the beneficiary. But college savers in general should be pleased with how their portfolios held up during the bear market and recovered in the time since.
Most investors choose to put their money in an age-based option, which means that the asset allocation shifts over time from a stock-heavy portfolio to a more conservative bond-heavy portfolio as you approach that all-important enrollment date. 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 this crash set them back and how much time that, on average, they needed before an investor could get back to even.
So, families with 18-year-olds typically needed about a 3.5% return between March 2020 and August or September of this year when enrollment starts. Sounds pretty tough, but instead they earned an average of almost 6.9% by the end of July 2020, easily clearing the hurdle and ensuring no meaningful loss of capital before move-in day. But for younger beneficiaries the hill decline was a little bit steeper. Age-based options further out from college lost more than 19% in some cases. Most of these portfolios at that point are still in equities, which in the first quarter were extremely sensitive to the path of the virus across the U.S. and across the world.
But instead what we've seen is a rally led by this optimism for a vaccine and some of the biggest names in the index adapting well to a mass work-from-home environment. And that's resulted in every age-based and target-enrollment category average earning back their Q1 losses already, with a little bit leftover. So, investors have reason to feel encouraged.
Dziubinski: Let's talk a little bit about different scenarios for folks who may have different situations with beneficiaries of their 529 plans today. One might be they have a beneficiary who is getting close to going to college and is starting to think about delaying it or deferring it. Should those people continue to invest in the 529 plan?
Hume: Absolutely. It's a good question, and some families are really struggling right now. So, it's not always a possibility. But if they are financially able, we find that generally the answer is yes. Our research finds that any year that investors do not contribute to a 529 account, they reduce the capacity for their savings to capture and compound investment returns. Since most investors 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 set an investor closer to the 18-year time horizon that most 529 plans are designed for.
To put it into context, for a $50,000 total savings balance, opening the account just one year earlier at age 6 increased the ending account balance in our study by roughly $4,000, which is quite a lot of textbooks.
Dziubinski: In addition to the compounding you get by investing longer in a 529 plan, what are some of the other benefits?
Hume: There are a couple--mostly having to do with tax benefits at both the federal and the state level. So, federal tax savings are available to every 529 investor regardless of what state they live in or what plan they are invested in. College savers can allow their money in a 529 plan to grow without incurring taxes on their investment gains. State income tax benefits are another benefit enjoyed by about half the country. Income tax benefits are granted based on contributions rather than investment gains, so they incentivize continuing to put money into that 529 account. But income tax benefits also vary pretty significantly, even among those states that do offer them, which makes it tricky to provide unilateral advice. That's the reason that in our new ratings methodology that we debuted this year, we refrained from considering tax benefits when assigning a rating, and generally, we find that it's a decision best left to individuals. But we did research whether it was possible to cover the average fee of a plan's age-based portfolios with the available state's specific tax benefits. What we found was that as long as you continue contributing, more than half of the state's tax benefits do cover the direct-sold plan's expenses for more than a decade. Over that time horizon, you're basically receiving free investment management. So, while there are many personal factors at play, there's no investment reason really not to hold firm and keep contributing if you can.
Dziubinski: And Madeline, lastly, what if you have a situation where the beneficiary of a 529 college savings plan decides for whatever reason that he or she does not want to pursue higher education, does not want to go to college. What then happens with those 529 plan assets?
Hume: Luckily, there are several ways for accountholders to repurpose the savings that are 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 be just 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 that 529 plans can be used to pay for apprenticeships in skilled trades, private K-12 education, and even $10,000 of existing student loan debt either for the intended beneficiary or a sibling. So, even if the child takes a nontraditional path toward education or chooses to defer it entirely, you can still get your money's worth out of your 529.
Dziubinski: Madeline, thank you so much for your time today and for your insights in this very interesting time for college planning.
Hume: Thank you for having me, Susan.
Dziubinski: I’m Susan Dziubinski for Morningstar. Thank you for tuning in.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.