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During good times, there's nothing more satisfying than investing in stocks and watching your portfolio value move steadily upward. But when turbulence hits, many investors reflexively head for the exits. Unfortunately for those who don't have much experience with investing, many financial companies make it easier rather than harder for their customers to do exactly the wrong thing during market panics.
One place where this phenomenon runs rampant is in the world of 529 plans. These college savings vehicles have many useful benefits, but they also require you to choose from a limited selection of investment choices -- some of which won't give you the returns you need to achieve your savings goals.
How 529 plans can be a smart move
In theory, saving for college with 529 plans makes a huge amount of sense. Like a Roth IRA for retirement savings, 529 plan accounts allow you to make contributions on an after-tax basis, and you don't have to pay any tax on the earnings from the account while you're accumulating money within the 529 plan. Moreover, as long as you use the money for approved school expenses, the income becomes tax-free -- giving you a big tax break in helping to finance your children's education.
The downside, however, is that 529 plans don't give you carte blanche to invest in whatever you like. Similar to employer-sponsored 401(k) retirement accounts, 529 plans have a fixed slate of investment choices from which you must select ones that will work for you. That can open the door to big problems, especially when the investment choices you have don't match up well with your risk tolerance and your overall investing strategy.
Diversifying in the wrong direction
In fact, 529 plans often seem to give participants new investment choices at precisely the wrong moments. For instance, as SmartMoney reported last night, several states have recently made changes or added new investment choices to their 529 plans, seemingly in response to the big drop in the stock market during August and September. Here are a couple of them:
- AllianceBernstein (NYSE: AB ) has added a feature that will allow it to reduce risk levels of 529 investment portfolios whenever its managers expect periods of higher volatility.
- Fidelity has added multimanager investment options to its plans in Massachusetts, Arizona, Delaware, and New Hampshire.
- Nebraska plans to add a choice to two of its plans that will act like a bank account rather than offering exposure to the stock market.
These moves may seem to make sense in light of the terrible performance in stocks over the past few months. But as usual, these moves come too late to do anyone any good -- and they encourage scared savers to flee stocks after the damage has already been done.
A common occurrence
It wouldn't be the first time financial companies have benefited from investors moving in the wrong direction. After the market meltdown, insurance companies Prudential (NYSE: PRU ) , MetLife (NYSE: MET ) , and Lincoln Financial (NYSE: LNC ) all experienced big gains in variable annuity sales even as they implemented cost increases or reduced guaranteed benefits. Yet after the plunge that lopped off more than half of the S&P 500's worth, the value of those guaranteed benefits was much less than it had been when the market was much higher. Low-risk savings options like bank accounts may reduce volatility, but they come at a similar price: sacrificing return.
Similarly, higher-cost investment options can sap more of your college savings return than you can afford. Fidelity's new offerings will cost significantly more than index fund choices you can set up on your own. Yet like competitors Franklin Resources (NYSE: BEN ) , Legg Mason (NYSE: LM ) , and Invesco (NYSE: IVZ ) with their 529 plan investment options, Fidelity benefits from more fee income when investors choose higher-cost investments.
Don't pay for this education
It's tempting to try to run away from the stock market when your college savings account is hitting the skids. But over the long haul, the best chance you have to afford college will come from having a balanced portfolio that includes stocks. If you bail out entirely, you could well make it impossible to save up the money you need.
Even if your 529 plan doesn't let you own individual stocks, they're still worth looking at for college savings. Get some great ideas in the Fool's free special report "5 Stocks The Motley Fool Owns -- And You Should Too." In it, we share some of our best picks -- and tell you how you can cash in on them.