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Ask Money

Saving for college

Chris Farrell Dec 30, 2009

Question: Hi – My wife and I plan to start saving for our daughter’s college education. Since it would provide tax-free growth of after-tax dollars, a 529 plan with flexible investment options will suit us well. Given, however, that we intend to allocate some portion of our college savings to fixed income instruments, are there any disadvantages to investing in muni bonds & funds outside of the 529 plan? We think we may be able to shield at least that portion of the savings from 529 limitations such as annual gift caps, lifetime limits and use-specificity, while still garnering similar tax advantages. What’s your opinion? Many Thanks, Sami, San Francisco, CA

Answer: I think it’s a good strategy to save some money for your daughter’s college education outside of a 529 plan. As you say, this savings doesn’t have any strings attached to it and there is a lot of value to financial flexibility. You can tap it for college expenses or, if that isn’t necessary, you can use spend on an adventure in retirement. The savings will allow you to do whatever makes the most financial sense when she is about to head off to university. I would emphasize safety and diversification with the savings.

I also like your idea of putting a core amount of money into a tax-deferred and eventually tax-free 529 plan (so long as the money goes for qualified educational expenses). One limitation I wouldn’t worry much about, by the way, is the amount you can set aside in a 529. For instance, the California 529 plan managed by Fidelity accepts contributions until all account balances in the plan reach $320,000 for the same beneficiary, according to savingforcollege.com. That’s a lot of money, more than you’ll need to set aside even if she ends up at an expensive private college like Harvard or George Washington University.

Tax-exempt bonds can be a good investment for individuals and families in a high tax bracket. But if you do put money into munis I’d stick with the highest quality fixed income securities. After all, California, the nation’s most populous state and the eighth largest economy in the world, keeps flirting with fiscal disaster. Another 9 states aren’t in much better fiscal shape, according to a recent study by the Pew Center on the States. Even after taking into account fiscal help from Washington D.C. state governments face a projected budget deficit of $350 billion for fiscal 2010 and 2011, according to the Center for Budget & Policy Priorities. The financial pressures won’t ease up any time soon.

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