ETFs and 529 Plans: Two Smart Money Moves That Don't Go Together

college piggie bankWhenever Main Street has a problem, Wall Street's answer is to come out with a new financial product to address it. Lately, that product has more often than not been an exchange-traded fund.

But sometimes, the ETF puzzle piece doesn't really fit into the spaces where Wall Street tries to place it. One example is in the popular college savings plans known as 529s.

With college getting more expensive all the time, savvy parents and relatives are doing everything they can to plan in advance for children's educations. One of the most popular ways is by using 529 plans: tax-favored college savings programs sponsored by state governments that let your money grow tax-free as long as you use it for higher education expenses.

Like regular portfolios, 529 plans took a big hit during the bear market four years ago, as many plans had large percentages of their assets invested in stocks. Those losses caused interest in the plans to wane, which in turn has forced the financial companies that manage them to come up with innovations to try to attract new assets.

Release the ETFs!

Recently, several states, including New York, Nevada, and Nebraska, have introduced ETFs as investment options in their 529 plans. Some program managers point to the greater trading flexibility of ETFs, which let you trade at any time the markets are open. By contrast, the mutual funds that most 529 plans primarily invest in only allow buying or selling once each day.

But ETFs really aren't well suited to 529 plans. The biggest reason is that while ETFs make frequent trading easier, the rules governing 529 plans don't allow frequent trading. Participants are only allowed to shift money across investment options once every year, and although you can direct new contributions to different investments at will, under those circumstances, the advantages of ETFs over index mutual funds are minimal.

ETFs do have a cost advantage over actively managed mutual funds, whose annual expenses can average well over 1%. But that may well change as more ETFs turn to active management strategies as well.

In most cases, 529 plans would get the same (if not better) performance by adding low-cost index mutual funds rather than ETFs. As useful as ETFs can be elsewhere your portfolio, they don't suit 529s, and offering them as an option looks like little more than a gimmick to capitalize on ETFs' positive reputation.

For more on smart family money moves: Fool contributor Dan Caplinger has relied on low-cost index funds in ETFs for seven years and counting. You can follow him on Twitter here.

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Larry Standridge

The real problem is not the investments but the entire structure of the Government regulated savings structure in the US. Start by getting rid of the entire structure all the ERISA products and guidelines. Create just two types of investment accounts Pre-Tax Investment Tax-Deferred and After-Tax Investment Tax-Free and make them like a IRA or ROTH where the individual controls the investments or hires someone to manage it for them either way their choice and responsibility. Then make a list of all the approves distribution methods from all current government plans and allow them without penalty from these accounts college, retirement, one time home purchase .... assess the same 10% penalty for withdrawals outside the current approved structure and limits to the contribution should be based on a percentage of the client income not a static amount as high income earners have a need for higher contributions in real dollar terms to maintain their lifestyle in retirement. Allow employers to contribute directly to the individuals plan after the method of vesting has been met by the employer. This gives a client one account to manage all types of needs and allows a benefit of concentrated higher balances within these accounts benefiting from a higher compounding rates of return the true builder of wealth in the world and allows greater oversight as a client has a single invesment vehicle for saving and investing instead of 5-6 which do not get frequent attention and suffer greater losses through negligence. In a final and way to complicated for Congress to understand addition to these accounts allow them to be sleaved so a client can have multiple investment disciplines within the same account to manage a time-horizon investment structure like time segment allocation for income planning purposes. But I think I went to far on that one???

September 02 2012 at 12:13 PM Report abuse rate up rate down Reply