Uncover 529 Investing Puzzle Strategies

Chandan Sengupta

Physician's Money Digest, January15 2004, Volume 11, Issue 1

If you're a physician-investor wholikes solving puzzles, you may enjoythe challenge of figuring out the bestinvestment strategy for your 529college saving plans. For most of us, it's aheadache we could do without. But thetax benefits of 529 accounts are wellworth the challenge.

Some flexibility:

Section 529 plans offer a plethora ofchoices—including a number of badchoices. They also incorporate manyrestrictions that make managing investmentsmore complicated than theywould be in other accounts (eg, IRAs).You have to use a 529 plan sponsoredby a state; you can't just open anaccount at any financial institution. You can use any state'splan; you're not constrained to usingyour own state's, although there may betax benefits for doing so.

Key Restriction

The key restriction in 529 plans isthat you can move the money already inthe account from its current investmentportfolio (eg, a large cap stock portfolio)into other investment options (eg, asmall cap stock and a bond portfolio)only once a year. On the surface, thismay not sound very restrictive. After all,if you're a long-term physician-investor,why would you want to make switchesmore often? Normally you won't. Butthis restriction can become problematicin some circumstances.

First, if you have not been savingregularly over the years and want tomake large catch-up contributions, youcan't put the money into a money marketportfolio inside the plan and thenmove the money into stocks using dollar-cost averaging over an extendedperiod of time, which you can andshould do in an IRA account.

An extreme example:

You and yourspouse could make a joint one-time contributionof up to $110,000 free of gifttaxes to the 529 plan. It would beunwise to plunk it into a stock portfolioall at once, but you can't easily spreadthis money out in stocks over time.

The restriction will also matter whenthe account's beneficiary is getting closeto college age. Ideally, you would eitherswitch money from stock portfolios tosafe-investment portfolios (eg, short-termbonds) on a monthly basis over afew years or you would do the switchingopportunistically (ie, sell stocks fromtime to time when the market is high).But under the constraints of 529 plans,you can't do that.

Contribution Options

For these reasons, it's best to contributeto 529 accounts through consistent,periodic investments (eg, monthlydirect debits from your bank account).Thus, you automatically get the benefitof dollar-cost averaging. Unfortunately,this does not work at the back endwhen you want to move money fromstocks to safe investments.

Another approach is to use age-basedinvestment options. The investmentmanager automatically investsmore of your contributions in stockswhen your child is young and slowlymoves the money into safer investmentsas they approach college age.

Some good news:

Another restriction you should beaware of is that you can switch from onestate's plan to another (ie, roll over) onlyonce a year. In addition, if you switch outof your state's plan, you may have to paystate taxes on the investment returns theaccount earned over the years, and if youhad received tax deductions for your contributions,you may have to refund thestate. You can directnew contributions to any investmentoption you want.

Many 529 plan investment optionsand restrictions are politically motivated.They are likely to get worse, not better.Physicians with sizable portfolios canbypass some of the investment problemscaused by these restrictions by managingtheir 529 plans as parts of their overallportfolios. That requires a solid understandingof asset allocation and portfoliostructuring. If you are uncomfortable inthese areas, seek professional help.

Chandan Sengupta, author of TheOnly Proven Road to InvestmentSuccess (John Wiley; 2001), currentlyteaches finance at theFordham University GraduateSchool of Business and consultswith individuals on financial planning and investmentmanagement. He welcomes questions or commentsat chandansen@aol.com.