More families add to 529 plans

The nation’s $1 trillion student debt problem may have a silver lining: More families seem to be socking away cash in tax-free accounts for college expenses.

The nation’s 86 different Section 529 college savings plans held a total of $166 billion in assets at the end of 2012, up 25% from the end of 2011, according to a Morningstar Inc. report.

Much of that increase is due to investment gains, said Laura Lutton, director of funds-of-funds research at Morningstar. The S&P 500 rose 16% and the Barclays U.S. Aggregate Bond Index gained 4.2% in 2012.

But parents and grandparents have been adding more cash to these investments in recent months. For all of 2012, net inflows into the plans were about $14.7 billion.

Increasing inflows are likely due to the dramatic growth in college student loan debt and the discussions that that has sparked, Ms. Lutton said.

“Parents are heeding the warning and putting more aside to pay for college,” she said.

Americans owe $1 trillion in student loans, and the average student borrower last year owed $23,829, an increase of 30% since 2007, according to TransUnion LLC.

Although more new money flowed into 529 plans, the plan investments are underperforming similar mutual funds offered outside the plans, according to Morningstar.

A review of eight Morningstar categories of non-age-based portfolio options in 529 plans found that they returned less than the mutual funds in those categories over a five-year period, Ms. Lutton said.

Investments in conservative allocations in 529 plans, for instance, earned 3.73% a year, on average, for the five-year period through Feb. 28, compared with 4.34% for similar mutual funds, she said.

Age-based options also trailed their blended benchmarks, the Morningstar report said.

However, the results do not mean that 529 plans are a poor savings vehicle. In fact, the tax benefits at the federal level, and in some cases, the state level, would make up the difference over time, according to Ms. Lutton.

Investments in 529 plans grow tax-free as long as the funds are used for college expenses, and some states offer their residents who open accounts a state tax deduction.

“The 529 investment option returns haven’t kept up with similar mutual funds in recent years, though we expect the performance gap to close over the long term because of the tax benefits of 529 options,” Ms. Lutton said.