Balance Risk, Reward by Diversifying College Savings

Mike Chapman, an attorney in the Cincinnati area, describes himself as a bit of a "risk taker," so he and his wife decided to take an aggressive college savings investment strategy for their two sons, ages 3 and 8.

"Even if we invest aggressively, the total amount available is not going to come close to what we're going to need for college," he says.

They chose the Vanguard 500 Index Fund, he says, because its low-cost portfolio of stocks is designed to track the Standard & Poor's 500 index. By investing within with the Ohio 529 plan, he also reaps tax benefits -- a state tax deduction and tax-free withdrawals for qualified higher education expenses.

However, as he's watched the stock market tumble since the beginning of the year, Chapman says he may consider shifting to more conservative assets as his sons get close to college age.

College costs present a tricky target for many families. The expenses are intimidating and, in recent years, rising at a rate above inflation, according to the College Board, a nonprofit organization devoted to college readiness.

That means saving in a conservative vehicle, like a regular savings account, likely won't keep pace with soaring costs. On the other hand, investing aggressively in the stock market puts the investment at risk.

The key, experts say, may be to consider diversifying your portfolio.

"A diversified portfolio has the potential to benefit you in the long run in helping to both grow and preserve the capital that you have put in to work for you," says Jim Eutsler, wealth advisor at Ohio-based Hengehold Capital Management LLC.

Here are some ways to do that, both within a designated college savings account, such as a 529 plan, and by combining savings vehicles.

[Learn who can benefit from 529 plans.]

-- Diversify your college savings fund: Some 529 plans offer age-based portfolios, similar to target-based retirement funds, which can be made up of a mix of stocks, bonds and sometimes cash. As the beneficiary nears college, the portfolio is automatically steered to a more conservative risk level.

Eutsler says these portfolios also tend to offer diversification even within classes of stocks and bonds; for instance, some domestic, some international.

"If (the investor) would be comfortable with the allocation of an age-based portfolio, it may not be the 'be-all end-all,' but it could go a long way in providing peace of mind that you are diversifying," he says.

Investors can also customize their own fund. Within a 529 plan, investors can choose relatively safe assets such as bank certificates of deposits, which are insured by the Federal Deposit Insurance Corp., or a money market account. They could choose to open two accounts -- with two different risk profiles -- or open just one 529 and create their own blend of asset types.

"You could choose to mimic (an age-based plan) on your own, tailoring it to what you feel comfortable doing," he says.

[Know when to shift age-based college savings.]

-- Mix and match vehicles: Families could also consider mixing and matching designated education savings accounts, such as 529 college savings plans or Coverdell Education Savings Accounts, with other pools of money that could be put toward college.

"Diversifying among the type of vehicles gives you more flexibility as to what you can do," says Sam Fawaz, certified financial planner and president of Y.D. Financial Services Inc., a fee-only financial planning firm with offices in Michigan and Tennessee. Fee-only means commissions aren't received for selling or recommending certain products.

Fawaz says he has some clients who worry about over-funding their 529 accounts. If withdrawals aren't used for qualified higher education expenses, 529 investors could face taxes and a 10 percent penalty on the earnings.

One way to hedge this, he says, is to use both a 529 plan and a Roth IRA. In a Roth IRA, the principal can be withdrawn tax- and penalty-free at any time, although the earnings are only tax-free when the account-holder reaches 59 ½.

"The Roth basically gives the flexibility of using it for your kids' college or for your own retirement," he says.

Another possible combination is to use a Coverdell ESA and a 529 college savings plan together.

[Learn the pros and cons of using a financial advisor for college savings.]

Like 529s, Coverdell Education Savings Accounts offer tax-free investment growth and tax-free withdrawals for qualified expenses. They can also be used for certain K-12 expenses, not just college. Restrictions include a $2,000 contribution limit per year, plus a cap on income eligibility.

Any Coverdell funds not used for K-12 expenses could be put toward college, and there's more individual security selection available through Coverdells, Eutsler says.

"In a Coverdell, the universe is much, much broader," Eutsler says. "You could pick any of the funds out there offered at the specific brokerage that you have a Coverdell established through. There could be thousands of options that you have to diversify from."

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

Deborah Ziff is a Chicago area-based freelance education reporter for U.S. News, covering college savings and 529 plans. You can follow her on Twitter.