College savings plans sponsored by the states looked like sure bets when they came on the scene during the bull market's heyday. But three years into a bear market, the Standard & Poor's 500-stock index is down 40%, while tuition was up 9.6% at public schools and 5.8% at private schools over the past year alone. With many accounts showing big losses, shellshocked investors and plan sponsors are rethinking their strategies.
The biggest change is that these 529 plans, named for the section of the tax code that created them, are adding more conservative investment options, including bond, money market, and stable value funds. Stable value funds -- which have returned 3% to 4% on average over the past year -- are designed to preserve principal and throw off modest income by investing in conservative instruments such as insurance contracts that promise a fixed yield over a period of time.
RAINY DAY INVESTMENTS. About 25 states now offer some form of stable value product, double the number a year ago, says Joseph Hurley, founder of Savingforcollege.com, a Web site that provides information on 529 plans. In January, for example, Colorado added a stable value investment option from Travelers Insurance to its five other alternatives, including equity, fixed-income, and balanced funds. Other plans with new stable value offerings include those sponsored by Texas, Alaska, and Ohio.
A slew of other states, including New York, California, and Connecticut, offer guaranteed funds that also preserve principal, while paying a fixed interest rate for a period of time. Currently, New York's guaranteed option pays 3.8%, while California's returns 3.6%, and Connecticut's yields 4.25%. All of these less risky offerings "provide families with at least some assurance that they can preserve capital during rough times," says Diana Cantor, executive director of the Virginia College Savings Plan and chairwoman of the College Savings Plan Network, the national association of state 529 sponsors.
That doesn't mean you should pull all your money out of stocks and throw it into rainy day investments. As a general rule, the younger your child, the more risk you can afford to take and the more you should stash in equities (table). Moreover, if you put everything into bonds and stable value funds, you may miss out on the chance to profit from a stock rally. And with returns of 3% to 4%, you'll never get ahead of college cost inflation.
Once you have ascertained how much you wish to devote to nonstock investments, make sure the plan you're in offers the best selection. Many people choose their home state's plan because they get incentives such as state income-tax deductions for making contributions. But if your state doesn't offer the kind of funds you want, consider switching to another state's plan. You can also keep your current account while opening a second one elsewhere. In fact, you are free to fund as many 529 accounts as you like. When comparing similar investment options among different 529 plans, favor those with the lowest fees. For example, New York's plan charges 0.60% for its guaranteed option, while Alaska's Manulife College savings plan charges 1.40%.
PENALTY-FREE CHANGES. For those who want to shift their holdings, the good news is you have more flexibility to do so than ever before. Investors in 529 plans have always been allowed to adjust their asset allocations by shifting money into new investments when naming a new beneficiary for an account. But now, thanks to tax law changes unveiled in 2001, you're entitled to make two penalty-free changes to your 529 portfolio each year without naming a new beneficiary -- one shifting assets within your current plan and a second moving assets into another state's plan.
Suppose you have all of your college savings in an equity fund within Indiana's CollegeChoice plan but want to take a more balanced approach -- such as 50% in stocks, 25% in a money market fund, and 25% in bonds. Simply direct the plan to take half the money in your account out of the stock fund. Then, divide this amount between the plan's money market and bond offerings. Although you are shifting money among three investment options, the moves count as a single change since they occur simultaneously, says Hurley.
When moving your money, be careful not to trigger any penalties. If you allow more than 60 days to elapse before reinvesting a 529 withdrawal, you will be liable for a 10% penalty plus income tax on your earnings from the fund, says Hurley. Of course, if you have no profits, there's no need to worry. (In fact, if you cash out with losses in your account, you may be able to deduct them on your tax return. Check with your accountant.) An alternative to cashing out and reinvesting is to open a new account and request that your money be transferred. Just keep in mind that a growing number of plans impose fees on rollovers. Generally, you can expect to pay from $30 to $50, Hurley says.
If you received a tax deduction for your 529 investment, you may have to pay it back if you pull your money out. Some states -- including New York, Montana, and Rhode Island -- levy such penalties, Hurley says. New York says it intends to go a step further by imposing state income taxes on investment profits that are transferred to other state plans, he adds.
Last, if you invest in a 529 plan through a broker, be aware that you may be subject to sales charges levied upon withdrawals. For instance, investors in Ohio's Putnam CollegeAdvantage Savings Plan could forfeit as much as 5% upon withdrawal.
If the do-it-yourself investment approach sounds daunting, you can opt for an age-based portfolio that automatically shifts to a more conservative asset mix as your child gets closer to college age. Age-based portfolios are now standard fare in 529s: Only the programs sponsored by Louisiana, Montana, and Washington lack this option. TIAA-CREF, the largest manager of college savings plans, says 60% of its $3.78 billion in 529 assets resides in the age-based portfolios it directs. Still, investors in age-based funds have not escaped losses of as much as 20% over the past year.
Sure, it's harder to keep up with tuition when the markets aren't cooperating. But at least the 529 world is offering more choices to help you cope.
By Fran Hawthorne
With Anne Tergesen
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