Can College Savings Be Saved?

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Students are facing a crisis, as they struggle to afford the education they want and need. But while many focus on the impact of student-loan debt on young adults, few are looking at the other side of the coin -- namely, the incentives promoting college savings that in many cases aren't getting the job done.

A problem on both sides
The rising cost of college has set off a firestorm of debate. Skeptics argue that the rising tide of student-loan debt and ever-increasing tuition costs have reduced the economic benefit of going to college. And while proponents point to increased pay after earning a college or graduate degree, others -- including Fool contributor Brian Stoffel -- have questioned whether there aren't less expensive ways to get the knowledge and experience that will help young adults succeed and prosper in their careers.

But in the ideal situation, students wouldn't have boatloads of debt to deal with because their parents would have been able to set aside enough money to cover their college educations. One vehicle that was established precisely to encourage college savings, the 529 plan, has seen some trouble attracting savings from some quarters -- and even some of the industry professionals that earn handsome incomes from such plans are starting to lose interest.

86ing 529s
With 529 plans holding billions in assets, it may seem surprising that some money managers are abandoning the market. But as The Wall Street Journal reported over the weekend, Wells Fargo (NYSE: WFC  ) chose not to keep managing Wisconsin's 529 plans (effective later this year), and Fidelity made a similar decision with its California plan.

Part of the problem comes from the trend toward lower-fee investments. With index-tracking exchange-traded funds charging fees that are far less than actively managed mutual funds, the higher-cost investment options that AllianceBernstein (NYSE: AB  ) , Hartford Financial (NYSE: HIG  ) , and other active-management firms have within some 529 plans come under greater pressure from the state board established to oversee the plans.

But one clear component of dissatisfaction with 529 plans has been the losses that investors have suffered during the market's volatile stretch since 2008. Unlike retirement savings, in which many investors have decades to recover from a loss, the time horizon for college savings is by definition shorter. A badly timed market downturn can spell disaster for college savers, and the threat of stock market losses has turned off potential investors from badly performing 529 plans.

That risk has prompted broader investment offerings from 529 plans, including bank CDs and other fixed-income options. Although Fifth Third (Nasdaq: FITB  ) and some other banks have benefited from increased CD volume through those offerings, low rates aren't helping college savers.

A better alternative?
Despite attempts to broaden their investment offerings, 529 plans suffer from the same problem as employer 401(k) retirement plans: a limited menu of options. Even considering that all 50 states offer at least one 529 plan of their own, none of them gives you more than a handful of investments to choose from.

The better solution would be to expand another, more flexible tax-advantaged vehicle that already exists. The Coverdell Education Savings Account acts like an IRA, letting you invest in just about anything you want. As long as you use the money for educational expenses, the income you earn is tax-free when you take it out. Yet despite allowing people to save hundreds of thousands of dollars in 529 plans, the annual limit for Coverdell ESAs is a piddling $2,000 -- and that number is slated to go down to just $500 next year if the bigger contribution limit isn't renewed.

It's not too late
529 plans were a good idea for college savings. But it's increasingly clear that in the tug of war between states trying to draw revenue from administrative fees and financial companies trying to maximize their own revenue, the entire purpose of the plans -- helping people save for a college education -- has been put on the back burner. Until policymakers remember that purpose, 529 plans may well continue to suffer a decline in interest from both savers and the financial community.

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Fool contributor Dan Caplinger is hedging his bets with a variety of savings vehicles, including Ohio's 529 plan. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Fifth Third Bancorp and Wells Fargo, and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't 86 you.

Read/Post Comments (8) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 30, 2012, at 11:44 AM, JGBFool wrote:

    I had not heard that about the contribution limit to the ESA being reduced to $500. That's terrible news.

    I like the flexibility that the ESA offers-- I can manage it myself, so I've been mostly loading it with small-caps since my kids' college educations are still far off.

    I guess the fact that people can manage an ESA themselves is the reason that the contribution limit will go down.

    Congress has no interest in working for middle class Americans, and people who manage their own investments don't have a powerful lobby to buy the votes of "our" Senators and Representatives.

  • Report this Comment On April 30, 2012, at 3:19 PM, danbranky wrote:

    The gov't should allow a plan similar to a Health Savings Account where you can chose an amount to come out of your pay every month, tax free, and that would have to be used to pay for education. So if tuition cost is $18K per year, the parent can chose to allocate maybe $1K per month and that would equate to an impact of about a $650 per month after taxes. It would greatly reduce the amount of money that our children would need to borrow. In this case, the student would borrow the additional $6K per year.

  • Report this Comment On April 30, 2012, at 4:00 PM, KwizatzHaderach wrote:

    @danbranky - Or they could stop using the tax code to mold our behavior into the images they like and do away with the income tax altogether. Then you could happily save tax-free for college or whatever else you want to.

  • Report this Comment On April 30, 2012, at 4:01 PM, KwizatzHaderach wrote:

    @danbranky - But on a more serious "what could we do in the short-term note" I like where you're going. One of the things that was frustrating to me was that you can't actually establish either a 529 or an ESA until the child is actually born. Why can't you just get a general-purpose education slush fund for your family? I was able to start contributing 3 or 4 years before I had a child, and that's a lot of compounding interest to miss out on. And then if I don't have kids, well, I pay the 10% penalty, and that's the risk I take.

  • Report this Comment On April 30, 2012, at 4:48 PM, CADavebert wrote:

    I've moved from 529 to Roth IRA. Basically the same, except I can choose what is invested, and can use it for retirement or education. It was too hard to look at the 529 only growing 1-2%, while my IRA grew double digits.

  • Report this Comment On April 30, 2012, at 5:28 PM, TheDumbMoney2 wrote:

    Actually I'm pretty sure that, as might be expected, Vanguard has a cheap and excellent 529 plan which they administer, and through which one can invest in a pretty broad array of things.

  • Report this Comment On May 01, 2012, at 9:12 AM, danbranky wrote:

    I'm going to call it the CEASE plan (College Education And Student Expense). This would allow you to put money into the plan tax free instead of just tax free interest as in other plans.

  • Report this Comment On May 02, 2012, at 8:41 AM, Marshalldedr wrote:

    Part of this challenege is over borrowing IMO. I put myself through school beginning in 1989 without parental support (both were deceased; and no, there was no estate to assist). I worked 30 hours per week, put off vacations etc. and graduated in 1991 with only $10,000 in loans. Now I hear about $100,000 loan amounts for basic four year degrees. I also hear about the lush vacations, spring-breaks etc. that were paid for using loans. Do we not also need to look at the OPM aspect of our current culture and the over use of leverage with regards to education?

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