Some parents and grandparents may hesitate to save for college in a 529 plan right now because of stock market volatility. The stock market goes up one day and down the next. But, it is more important to start saving as soon as possible, even if it means investing in a conservative portfolio with a low percentage invested in equities.
When a child is young, most investment professionals recommend that your portfolio be heavily weighted towards stocks in order to have the best chance of keeping up with tuition inflation. That’s why the age-based and enrollment-date portfolios in 529 plans are more aggressively invested for young beneficiaries.
This means that the investment mix of an age-based asset allocation is going to have a very high percentage invested in stocks for a newborn. As a result, the stock market swings are going to have a bigger impact on the value of the 529 plan. Nevertheless, when the child is young, less money has been invested and there is more time to recover from losses.
Dollar-cost averaging can reduce the risk of a volatile stock market. Instead of making a single large contribution to a stock-weighted portfolio, you make contributions in smaller chunks over time, retaining the extra funds temporarily in a money-market fund or other conservative investment. If the market suffers another downturn, you would be acquiring a portion of your shares at the lower price. (If the market sustains a rally, on the other hand, you will be missing out on some of the upside.)
The easiest way to use dollar-cost averaging with a 529 plan is simply to enroll in the program’s automatic contribution option. Either monthly or on some other scheduled basis, funds will be electronically transferred from your bank account into your 529 account. Most 529 plans accept automatic contributions with very low minimum-contribution requirements, often as low as $25 per month. Automatic contributions via payroll deduction may be another option, depending on the particular 529 plan and your employer’s payroll procedures.
For example, suppose the price of an investment goes up and down as shown in this table, which reflects a very volatile year for the stock market.
If you invested using dollar-cost averaging instead of a lump sum, you’d have 4.4% more shares. Also, your investment would be up 12.3% for the year, instead of 7.6%.
Let’s say you want to use dollar-cost averaging but prefer to make a single lump-sum contribution into the 529 plan. There are a few ways to do that.
- One way is to start off with the money in a conservative investment and reallocate among the program’s investment options two times per calendar year as permitted by the IRS.
- Another way is to establish two accounts, one that names yourself as beneficiary and invests conservatively, and the other that names your child as beneficiary and uses a more aggressive age-based or static option. As often as desired, you could request a rollover from the conservative account to the aggressive account. The rollovers qualify as tax-free since the beneficiaries (you and your child) are members of the same family.
But, these strategies are cumbersome, may not be particularly effective, and could be costly if the 529 plan charges a fee for rollovers.
[Editor’s note: This article was originally published on May 12, 2003 and updated on October 19, 2020 by Mark Kantrowitz.]