Damage Control for Junior's 529 Plan

How to protect your kid's college funds

Michael Kirlin of Tenino, Wash., watched as the money he had set aside for his three young children in tax-deferred 529 college savings plans shrank with the stock market. Then in March, he pulled out the $6,100 left of $6,600 he had put in a year before and stashed it in prepaid plans to cover tuition and fees when his children go to college. With tuition rising, he figured a guaranteed payback was a lot better than a loss.

Parents who have invested in those newly popular state-sponsored 529 plans have been slammed by the market along with everyone else. If your child is still in elementary school, you have time for a market rebound. But if Junior is within three or four years of college, you're in tough shape unless you've been shifting gradually into conservative investments such as money markets and bonds.

Even if college is years away, it's hard to be happy if your 529 plan was heavy into tech or other hard-hit sectors. One technology fund offered by Arizona was down almost 41% this year through June 30. Even some of New York's stock portfolios have losses approaching 22%.

For those in search of a good night's sleep, there are alternatives. One is to do what Kirlin did: Roll your money into one of the prepaid 529 plans offered in 20 states. The plans are set up so that if you put in a specified amount of money, either periodically or in a lump sum, they guarantee to cover the cost of tuition and fees in that state's public schools, no matter what inflation brings. They allow you to get the sum in cash if your kid picks a school in a different state. The downside: You give up the hope of making big profits on your contributions in any new bull market.

Another option is to switch some or all of your money from stocks to money-market or bond funds, or to the guaranteed portfolios offered by some states. Pension fund giant TIAA-CREF, which manages 529 plans in New York, California, and 11 other states, has an investment option that guarantees your principal and a minimum 3% annual return. Like other managers, it also offers traditional age-based portfolios that automatically shift your savings away from stocks and toward bonds and money markets as the child gets older, relieving you of the burden.

Finally, Joseph Hurley, founder of Savingforcollege.com, a Web site focused on 529 plans, offers a tax balm for sore investors. Those with 529 plans worth less than what was originally invested can take out the money without fear of the Internal Revenue Service's early withdrawal penalty, he says. That's because the 10% penalty applies only to earnings. The plan may also levy its own penalty.

The IRS hasn't decided the tax treatment for losses on 529 plans. It may treat them as they do other capital losses. But Hurley guesses it will regard them as miscellaneous itemized deductions. You can't start deducting such items until they total 2% of adjusted gross income.

If you want to reopen a 529 for that child, you have to wait 60 days or it will be considered just a rollover of the old account (and therefore not a loss) rather than a new account. Things could get complicated if you have already given the maximum $11,000 annual tax-free gift to that child. The IRS might consider any money you deposit in a new 529 as another gift, in which case you may want to wait until January before starting anew.

By Carol Marie Cropper

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