When times are tough -- and times are undeniably tough -- it's easy to lose faith in the potential of the financial markets. People have told me they're not going to fund their IRAs this year, and I recently got a letter from someone wondering about the wisdom of 529 accounts for her kids given "the downward slide of the market." She was considering staying in cash or investing in Treasuries.
I understand investor fear and the reluctance to commit new money to the stock market given recent declines. But I also believe that what's going on in the markets today doesn't change the utility of 529 accounts for most investors.
529s: The Basics
First, realize that 529s are simply tax-advantaged accounts designed to encourage people to save for a child's college education. Their power lies primarily in the fact that they offer tax-deferred growth; in fact, all investment income generated in the account is tax-free as long as the proceeds are used for "qualified education expenses" (tuition, room and board, books and other expenses; the full details can be found in IRS Publication 970 at http://www.irs.gov). The risk of a 529 lies not in the account structure but the investments it contains -- which I'll discuss in more detail below.
Before you choose investments, though, you have to choose between two types of 529 plans: prepaid and savings. Prepaid plans allow you to pay future tuition at today's prices. Since higher education costs have been rising faster than inflation, this sounds like a good deal, but they're difficult to recommend. Most prepaid plans lock you into your state's public system of higher education (or even into a specific college), and they generally don't cover ancillary expenses. Savings plans are much more flexible. You choose how to invest the funds in a small spectrum of investment opportunities, and you can use the proceeds for qualified higher education expenses at any accredited college or university.