College

Salvage Your College Savings

Fix the mix in your 529 account, or consider a prepaid-tuition plan.

By Jane Bennett Clark, Senior Associate Editor

From Kiplinger's Personal Finance magazine, June 2009

Dip and valerie chandra look like the smartest parents on the block. About six years ago, they set up two 529 college-savings accounts for their children, Cerella and Axell. "We wanted to have the money saved before they went to college," says Dip. "It was a huge priority for us." They seeded the accounts with $6,000, and within a few years they had accumulated more than $8,000.

But that's not the smart part. Two years ago, Chandra took a job at a software company that pays by commission. With several big payouts, the couple, who live in Ashburn, Va., decided to switch gears and deposit two lump sums into Virginia's prepaid-tuition plan, covering four years' worth of tuition and fees at in-state schools for both kids. Meanwhile, their 529 savings accounts went south with the stock market. "We dodged a bullet," says Chandra.

Other families have not been so prescient -- or lucky. Last year, assets in 529 plans nationwide fell from $111.9 billion to $88.5 billion. Within those plans, many age-based portfolios, designed to become more conservative as a child grows older, lost by double digits even as students were turning 18 or older. At the same time, some prepaid-tuition plans -- which let you lock in tomorrow's tuition at today's prices -- are now underfunded (Virginia's plan is safe) in the face of rising tuition and sinking investments.

With all the carnage, should you get out, or stay out, of these state-sponsored programs? Probably not. The 529 savings plans still trump most other savings vehicles because they let your college money grow tax-free. If you withdraw the money for qualified education expenses, such as tuition, the money escapes tax completely (otherwise you pay income tax and a 10% penalty on the earnings). With the prepaid plans, you beat inflation by locking in tuition while college is still a twinkle in your kid's eye. And more than two-thirds of the states sweeten the pot by offering a tax deduction or credit for contributions to both types of plans. Still, neither program represents the last word on saving for college. And there's no need to risk the college money on a losing proposition. If the current plan isn't working out, fix it.

CHANGE THE MIX
Imagine opening your 529 statement and discovering that your high school senior's college savings had dropped by almost one-third. That was the case recently for participants in North Carolina's most aggressive age-based portfolio, which invests over half of its assets in stocks for students who are only one year away from college. The portfolio for students who were college freshmen lost more than 20%.

You would think an "age-based" account would spare you such anxiety. Designed to jump-start your college kitty in the early years and preserve it later on, the portfolios have you invest largely or entirely in stocks when your child is young and, theoretically, move to risk-averse investments, such as money-market funds and certificates of deposit, as your student approaches college age.

KIP TIP

Chart Your Own Course Want to steer your college fund through the high seas yourself? With a coverdell Education Savings Account, you can manage your own investments. You set up the account at a sponsoring institution, such as a bank or mutual fund. As with 529 plans, the money grows tax-free, but with the Coverdell, you can withdraw money tax-free for elementary and secondary-school expenses as well as college costs. To get in on this deal, your adjusted gross income must be $110,000 or less ($220,000 or less for married couples filing jointly). You can contribute up to $2,000 a year. You won't get a state tax deduction for the contribution, but you can roll the amount over to a 529 plan later without tax or penalty and grab the deduction then, getting the best of both worlds. The switchover works only in one direction. If you move the 529 account into a Coverdell, you pay tax and a penalty. Be aware that the Coverdell will revert to less-generous terms in January 2011 unless Congress extends the current provisions.

In fact, age-based portfolios now come in enough shades to fill a crayon box. Some grow ultra-conservative as students finish high school, and others allocate 30% or more of their assets to stocks even for students already in college. "States that have those larger allocations to equities were probably responding to investors who wanted to take advantage of stock-market gains even with an older child," says Douglas Chittenden, of TIAA-CREF, which manages eight state savings programs and a comparable program for private schools. "Last year clearly demonstrated the dangers of that approach."

You can't manage your investments in a 529, but you can pick the portfolio that best suits your goals. Normally, you can change the portfolio once in a calendar year. This year, Uncle Sam took pity on families who were having third thoughts and loosened the rule to allow two portfolio changes in 2009. You always have the option of changing plans once every 12 months by rolling the money into another state's 529 account, and you can switch beneficiaries -- say, from one sibling to another.

If your 529 savings crashed at the critical moment, one obvious strategy is to rid your portfolio of stocks and other ailing investments and substitute guaranteed-principal alternatives, such as CDs. Painful as it may be to lock in your losses, "if you feel sick about what you've lost so far, you'll feel a lot sicker if you lose another 15% to 20%, " says Deborah Fox, a college financial planner based in San Diego.

Most 529 plans offer at least one principal-preserving option, and states including Arizona, Utah and Wisconsin have recently added more. Investors are flocking to them, says Chittenden: "Typically, in October we have several hundred people who rebalance into our guaranteed option. In October of last year, we had several thousand people do so. Many of them were people with older beneficiaries. It was the logical thing to do."

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