Salvage Your College Savings

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.

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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.

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."

If you can cover college costs out of current income or other resources -- maybe even federally backed loans -- for a year or two, you might want to let your investments ride or switch the account to a younger beneficiary, a move that generally incurs no tax or penalty. Chittenden used that strategy with his own children. "My oldest son went to school in-state. I took his 529 money and changed it to be for my daughter, who's only 9. That lengthened the time horizon. If you've taken a hit, it gives you more time to make it back."

Families with young kids are safe sticking with stocks, says Nicholas Yrizarry, a financial planner in Northern Virginia who advised the Chandras (and suggested they switch to the prepaid plan). "Some families can't believe their portfolios are down 50%, but their children are 4 or 5. That horizon will work." As for parents of newborns or toddlers, the more stocks, the better, says Chittenden. "If ever there was a time to buy, now may be it."

By the time the kids are in their mid teens, the mix should adjust to about 80% short-term and intermediate-term bonds, cash and Treasury bills. As investors have discovered (sometimes to their dismay), you can't take that adjustment for granted. Before signing up, read the disclosure statement to see what portion of assets will be invested in stocks as your children grow older. Once you're in, check at least quarterly to make sure the investments are on track.

SHOULD YOU BAIL?

If your balance falls lower than the sum of your contributions, you have one small consolation: You can cash out the account and use the money for anything you like without owing tax or a penalty (no income, no tax). If you really had a rotten year, you might even be able to take the loss as an itemized miscellaneous deduction on your income-tax return. Only the amount of total miscellaneous deductions, including your losses, that exceeds 2% of your adjusted gross income qualifies for the break. You can't include miscellaneous itemized deductions in calculating your alternative minimum tax.

If you want to take the deduction and start fresh with another 529, you should wait at least 61 days after cashing out before investing the money in the new plan. Otherwise, the IRS might interpret the transfer as a rollover and deny you the deduction. Talk to your tax adviser before you make a move.

And don't even think about cracking open the piggy bank before checking to see whether your state reclaims tax deductions for contributions. Some states require that you return any deductions you took in previous years if you withdraw the money for nonqualified expenses or even if you roll it over to another 529 account. If that's the case, you should probably leave the account intact until you can make qualified withdrawals, says Joe Hurley, of Savingforcollege.com. Most plans give you plenty of time to cash out.

VET THE PREPAID PLANS

For the Chandras, locking in their college tuition meant "a huge sigh of relief," says Dip. Lately, more families have sought that stress-reducing strategy, says Richard Walsh, of Oppenheimer's 529 Group, which manages the Texas Tuition Promise Fund. "While investments were on the upside, there was not a lot of growth in prepaid plans. As people remember that the market doesn't always go up, prepaids have taken hold again in many parts of country."

Pricing arrangements for prepaid plans vary, but each offers families the chance to cover some or all of tuition and fees years ahead of enrollment. Result: You beat tuition creep, which has risen lately by more than 6% annually for public schools. And you don't have to worry that the Dow will crash just as the college acceptances start rolling in.

Prepaid plans are not designed for last-minute changes. Most states require that you buy in at least three years before your student enrolls, and you may have to enroll much earlier to minimize the premium that some plans impose on top of current tuition to fund future increases -- as much as 30% in some states. All the plans refund your investment if your child ends up going to school beyond state borders or to a private school, but the money likely won't stretch nearly as far as it would have at an in-state public school.

Nor are state prepaid plans for everyone -- literally. Fewer than half the states offer the plans, and all but two (Alaska and Massachusetts) restrict enrollment to state residents. To better fulfill their commitment to current members, seven states -- Alabama, Colorado, Kentucky, Ohio, South Carolina, Texas (for the Guaranteed Tuition Plan) and West Virginia -- have closed their plans to new investors. In some cases, returns on prepaid trust funds have plummeted at the same time that state legislatures are slashing support for higher education, forcing tuition up. "Prepaid plans are based on the tuition increase in your public-school system," says Rick Darvis, a certified college planner in Plentywood, Mont. "If they are going to keep up with a 6% or higher inflation rate and investments are going the other way or are not doing well at all, they're in trouble."

So far, no state prepaid program has failed to pony up for investors, but it's still a good idea to vet the health of a plan. See what percentage of future liability is funded; more than 100% indicates good health, says Savingforcollege.com's Hurley. A percentage below 100% doesn't mean the plan will run out of money tomorrow, he says. "But at some point, if things don't change, it will."

You'll also want to know what, if any, protection the state provides against future shortfalls. Several states offer a full guarantee or will consider a legislative fix if problems arise. In the Texas Tuition Promise Fund, Texas's newest plan, the schools, not the states, honor the purchases, lessening the risk to you. States that lack any specific remedy -- Alabama, Michigan, Nevada, Pennsylvania and Tennessee -- would probably close plan enrollment or raise premiums to new members before leaving you holding the bag, says Walsh. (Alabama recently did just that after the funded ratio sank below 70%.) If both the plan and the protection look tenuous, call the state treasurer's office and ask how long the funding will last under current circumstances and what the state would do after that. Steer clear if the answer does not satisfy.

THE PRIVATE OPTION

If you expect your student to apply mostly to private schools and you want to beat the 5%-plus annual tuition inflation at those institutions, consider the Independent 529 Plan. This program lets you lock in tuition and fees at over 270 private institutions, including Duke, Johns Hopkins, Stanford and Wesleyan.

Here's how it works: You buy a certificate that can be redeemed at any member institution for whatever percentage of schooling you purchased. Rather than impose a premium, the plan gives you a discount of at least 0.5% off the locked-in rate. As with state plans, you have to hold the certificate for at least 36 months. The schools assume the risk, so you don't have to worry that the pool will run dry before your child gets into the water.

Prepaying tuition into a plan that includes Duke and Stanford doesn't mean your student will be accepted at those premier institutions. If your child can't find a match among the participating schools or decides to attend a public school, you can switch beneficiaries to a younger sibling or move the money without penalty to your state prepaid program, although the three-year waiting period until you redeem the tuition still applies.

Or you can get a refund, plus or minus up to 2%, based on the performance of the overall fund. As with other tax-preferred education accounts, you'll owe taxes plus a 10% penalty on any earnings with withdrawals that aren't used for qualified education expenses.

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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.