Invest Well or Your Kids Will Blame You

When it comes to saving for retirement, a down payment on a home, or many other financial goals, you're the one who pays the price if you make a mistake. But if you're trying to get a jump on the high cost of college, your kids are counting on you to make smart decisions.

Many investors have turned to 529 plans to help with their college savings. Yet the bear market has had a huge impact on these savings vehicles as well -- and many of the professional managers that run plan investments have failed to prevent huge losses.

529 basics
529 plans closely mimic the features that Roth IRAs offer retirement savers. You don't get an upfront federal tax deduction for contributing to a 529 plan, but earnings within the 529 plan aren't taxed as you go. Furthermore, as long as you eventually use the money in the 529 plan toward qualified educational expenses, you'll never have to pay any tax on your gains.

That's an attractive feature -- that is, as long as those plans actually produce some gains. Lately, though, 529 plans have performed disastrously, and many parents have seen money they'd hoped to use to support their kids simply disappear.

Big mistakes
A Morningstar special report released yesterday gives many of the gruesome details. In a nutshell, though, the problems boil down to three simple mistakes:

• Many funds invested too aggressively for the relatively short time horizons they had to invest.
• Some of the bond funds offered by 529 plans fell prey to problems in the mortgage-backed securities market, causing major losses even in more conservative portfolios.
• Some plans offer few investment choices, which sometimes pushes investors into second-best options that aren't ideal for their particular situation.

That's not to say there aren't some great 529 plans out there. But even those weren't able to escape from a falling stock market. Investors who fell into the worst ones, on the other hand, really got burned.

What to look for
Wherever you live, your state offers at least one 529 plan. Yet, while you may get special benefits like state income-tax breaks by staying close to home, you can generally go anywhere you want if you find a better plan elsewhere.

Unfortunately, with that many plans to choose from, it can be tough to compare them all. The key attributes of a good 529 plan, though, come down to some of the same things you want from a 401(k) plan:

• Low fees, both from the entity that runs the plan as well as the investment managers who invest your money.
• A wide variety of investing options, including both "automatic" asset-allocation based funds and "do-it-yourself" investment choices that let you tailor your portfolio to your own situation.
• Strong fund managers that match or outperform their benchmarks.

In addition, transparency is important. You want to know exactly what you're investing in. For instance, here's a mix of investment funds offered by the Ohio College Advantage 529 plan, which Morningstar picked as one of the best:

Source: Morningstar. *Returns for underlying funds do not include administrative expenses of 529 plan.

As you'll see, none of those funds has made money -- but they've each done better than the 3.8% average loss turned in by Vanguard's flagship 500 Index Fund, which tracks the S&P 500. More importantly, it's easy to know exactly what you're investing in because the underlying funds report their holdings regularly. In contrast, with some 529 plans, it's hard to figure out exactly what you own.

Don't give up
Nothing is more depressing than seeing hard-earned money go up in smoke. But if you have a good 529 plan, stick with it -- and keep adding money at today's low levels. Over time, they'll still help you get your kids to college -- and your kids will thank you for your efforts.

For more on saving for a rainy day, read about:

• 5 shortcuts for time-starved investors.
• How you can save and still have it all.
• Now's the time to stay strong with your investing.