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Trying to Save for the Kids' College? It's a Bear

Authors: Stacey L. Bradford The Wall Street Journal

(c) 2009 The Wall Street Journal

If the bear market has kept you from setting money aside for your child's college education, you're not alone.

Because of the economic crisis, 47% of parents are saving less or aren't saving at all for their kids' education, according to a Gallup survey released in May by student-loan provider Sallie Mae.

While not saving for that degree may have felt like a smart move while the stock market was crashing, the need to fund your kid's college account has only grown. For the 2008-2009 school year, the average cost of attending a four-year public school for in-state residents -- including tuition and room and board -- rose 5.7% to $14,333, according to the College Board. The cost was up 5.6% to $34,132 for a private university. (These numbers aren't adjusted for inflation.)

Meanwhile, the value of 529 college-savings accounts sank 21% last year, according to Boston consulting firm Financial Research, leaving families with far less tuition money than they had counted on. A 529 plan is a tax-advantaged investment plan offered by individual states.

So, the question for many parents is: How should they save for their children's higher education going forward without taking on too much risk?

The first thing to recognize is that all investments in stock and bond funds, including those in college-savings accounts, are vulnerable to market fluctuations. And they can lose value just when you need the money, says Joseph Hurley, founder of Savingforcollege.com, which provides information on 529 plans.

For parents with young children, if there's another severe market correction, they can leave a portfolio alone and wait for the stock market to recover.

But as children get closer to college age, you won't necessarily have the luxury of waiting out a bear market. By the time a child is a sophomore or junior in high school, parents should move the majority of their education savings out of stocks and into more conservative investments, says Kalman Chany, author of "Paying for College Without Going Broke."

Most importantly, parents need to read the fine print and truly understand what they are investing in. Just because a mutual fund within a college-savings plan is described as "conservative," it doesn't guarantee the holdings are risk-free.

In April, the state of Oregon sued OppenheimerFunds because its Core Bond fund, which was described as conservative, held credit default swaps and other risky investments -- causing the fund to lose nearly 36% in 2008. As a result, participants in the Oregon College Savings Plan, the state's 529 savings plan, had a total of $36 million in losses last year.

Here's a rundown of the most popular saving options and their risks:

529 College Savings Plans

Provided the money is used for qualified college expenses, you can withdraw funds from a 529 plan free from federal income taxes. Some states offer additional tax advantages for residents. If the assets aren't used for education expenses, you'll get hit with a 10% penalty.

Each year, one parent can contribute $13,000 or the two together can put in $26,000. You also can invest $65,000, or $130,000 for two parents, at one time, provided you don't make another contribution for five years. Amounts above that are subject to the gift tax. For more information on individual state plans, go to Savingforcollege.com.

The risks: If the stock market tanks, you may not be able to unload your riskier investments. That's because these plans restrict how often account holders can make changes to their portfolios. Thanks to market volatility, plan owners can change their investment mix two times in 2009. But unless Congress makes that change permanent, you'll be restricted to just one adjustment per year starting in 2010.

529 Prepaid Tuition Plans

A handful of states, including Florida and Virginia, offer prepaid 529 plans that allow parents to lock in today's tuition prices for participating state schools. These are usually open only to state residents. (In terms of investments and tax advantages, prepaid plans generally work the same as other 529 plans, though individual plan rules can vary.)

If your child doesn't attend a participating school, you can get your money back with certain penalties. The Florida plan, for instance, will pay out the same amount as if your child attended a public in-state school. Massachusetts will return your principal plus interest accrued at the rate of the Consumer Price Index.

The risks: Some states have fallen on hard times and may not be able to stand behind their tuition guarantees. In Alabama, parents can roll over money into the state's Higher Education 529 Plan to avoid tax penalties or they can redeem their original contract payments, minus fees. If Florida terminates its plan, it will provide tuition for participants who are within five years of college.

There's also a prepaid plan for private colleges called the Independent 529 plan. Currently, more than 270 institutions participate. For more information on this program, go to Independent529Plan.org.

The risks: Participating schools claim they will stand behind their promise to lock in current tuition rates. But if your child doesn't attend a participating school, you'll get back only your principal plus a maximum 2% investment gain.

UGMA and UTMA Accounts

Through the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA), a child can own securities and other investments in his or her own name, provided a parent or another adult acts as a custodian on the account.

The risks: These accounts no longer are the tax haven they once were. Investment income used to get taxed at a child's low rate, under the so-called kiddie tax. Now, a child's unearned investment income above $1,900 is taxed at the parents' higher income bracket until the child reaches age 19 (or 24 if the child is a full-time student).

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