Parents scared of losing their child's college savings fund in equity markets are receiving a helping hand.
In response to state 529 plans losing anywhere from 20% to 50% over the past two years, Congress recently passed the Deposit Restricted Qualified Tuition Programs Act, allowing all state 529 college savings plans to add FDIC-insured CD products to their roster of investment options. Currently, eight states nationwide offer FDIC-insured 529 options, including Arizona, Montana, Ohio, Wisconsin, Virginia and Colorado, which are offering certificates of deposits.
While CDs offer investors principal security and sometimes guaranteed returns, critics argue that they could cause investors to lose money. Here's how to decide whether 529 CDs are right for your investment plan.
High security, low returns
"CDs make sense as the future college student gets older and you want to shift your money to more secure accounts," says Mike Prescott, executive director of the Ohio Tuition Trust Authority, the organization that administers the state's 529 plan. "Since the return on CDs is so low, many of our clients start using them when their children are in high school."
With returns ranging from 1 percent to 5 percent, certificates of deposits grow significantly slower than the price of education. According to the financial-aid website FinAid.org, tuition increases by 8% on average each year, meaning that a certificate of deposit with an average percentage yield of 5% would leave an investor short.
The advantage is that those low returns are guaranteed says Dan Davenport, chief marketing officer for College Savings Bank, the Princeton, N.J.-based agency that manages Montana's and Arizona's 529 plans.
"If you lose 40% of your college savings, you need to capture 80% to get back to where you were," he says. "That's an awfully big hill to climb, especially if your child is leaving for college soon."
Not all CD programs are designed the same. While College Savings Bank offers traditional fixed-rate CDs with low return rates, they also offer a CollegeSure CD plan that operates like a prepaid plan, allowing parents to purchase tuition at today's rate then cash it in later.
"(CollegeSure) is totally different than our other CDs," Davenport says. "Parents need to shop around to find what works best for them."
Less management responsibility, fewer investment options
Unlike 529 equity options that allow plan holders to change portfolio packages annually, some plans require holders of CDs to stay enrolled up to 12 years to gain the maximum returns. Even if the market skyrockets, plan holders locked into a five- or ten-year CD option can't take advantage without paying penalties.
"Buyers have to understand the limitations and restrictions of CDs before enrolling," says Larry Rosenthal, president of Financial Planning Services in Manassas, Va. "Some CD plans allow you liquidity, but some either won't let you get out or will charge you a penalty for withdrawing early."
While traditional 529 plan options allow plan holders to shift funds between investment options without penalty, Rosenthal says that those who pull out of certificates of deposit too early can lose some, and perhaps all, of the interest they gained from their plan. Before committing to CDs, Rosenthal encourages parents to get the facts on how long they'll have to stay with a particular CD and what happens if they pull out early.
"Just because CDs offer security, that doesn't mean you should sign on without knowing what you're getting," says Rosenthal.
Copyright 2010, Bankrate Inc.