When the stock market grows steadily, as it did in the late 1990s, saving for college is easy. But when the stock market drops by about 40% in a single year, as it did in 2008, saving for college becomes a more difficult proposition. Do you continue saving for college, and if so, how? Do you pull your money out of college savings plans? What are the likely consequences of these actions? What are the best strategies for saving for college when the stock market is so volatile?
Section 529 college savings plans will generally have performance that mimics the performance of the stock market as a whole. When the stock market drops, the value of the college savings also drops. It can be very painful for a family that dutifully saved for college for over a decade to watch almost half that savings evaporate in a single year. It is even more difficult when the losses occur just before the child enrolls in college or when the child is already in college. You can appeal to the college’s financial aid office for more financial aid, but most colleges are not making adjustments because they need to focus their efforts on families with more serious problems, such as job loss. Moreover, even if the college is making adjustments for investment losses, parent assets usually have such a small impact on the expected family contribution that the benefit of an adjustment for losses is negligible.
Are prepaid tuition plans any safer? Prepaid tuition plans are run under actuarial assumptions that stock market returns will exceed increases in public college tuition. But when the economy turns sour, these plans are squeezed from two directions: income decreases and expenses increase. First, recessions cause decreases in state income tax revenue, forcing budget cuts, with state support of higher education one of the first areas to get cut. Since tuition is one of the few sources of funding under a college’s discretionary control, public colleges make up the shortfall in state support by increasing tuition. This typically leads to double-digit tuition inflation. Second, even if a prepaid tuition plan is conservatively managed, stock market gains turn into losses during a recession. The combination of increases in tuition inflation and decreases in investment value leads to a situation where the prepaid tuition plan might not be able to meet all its obligations at some future date, usually 10-15 years in the future. But aren’t prepaid tuition plans guaranteed? Unfortunately, of the 17 state prepaid tuition plans, only seven have a formal state guarantee, and two are rather limited. Most prepaid tuition plans will react by either closing the plan to new investment or by sharply increasing the premiums they charge over current tuition rates.
So what can or should you do?
It is a given that the stock market will drop at least once a decade. Accordingly, one should plan for the possibility of losses when setting up a college savings plan. Using an age-based asset allocation strategy is one of the best approaches to dealing with this. An age-based asset allocation strategy starts off with an aggressive mix of investments, and gradually shifts the asset allocation to a more conservative mix as college approaches. For example, one strategy might start off with 100% stocks at birth, cutting the percentage stocks by 20% when the child turns 4, 8, 12 and 16. When college approaches, more of the college savings is in conservative investments, so even if the stock market plunges most of the money is safe. Parents of a toddler might suffer big losses on a percentage basis, but the dollar amount of those losses is smaller since they haven’t been saving for as long. Moreover, a toddler has many years ahead to recover from the losses.
Make sure you’re in the right asset allocation strategy. Two-thirds of families are in age-based asset allocation strategies. The other third, however, are probably in much too aggressive of a set of investments. Even some age-based asset allocation strategies, however, are a bit too aggressive. By the time the child is ready to enroll in college, no more than 20% of the college savings funds should be invested in stocks.
The IRS has issued a special rule for 2009
[1] that allows families to change investments in section 529 college savings plans twice a year. Previously, investors could change their investment strategy once a year and in certain other circumstances, such as a change of beneficiary or a rollover from one state plan to another. This change is effective only for 2009. This special rule allows families to adjust their asset allocations in response to the turmoil in the stock market.
But just because you can change your investment strategy doesn’t mean you should. If your asset allocation was inappropriate for your risk tolerance, perhaps you should switch to a more conservative mix of investments. But selling your investments now will just lock in the losses and may cause you to miss out on a possible recovery. For example, the 411.30 drop in the Dow Jones Industrial Index on November 12, 2008 was followed by a 552.59 increase the next day. Similarly, the 203.18 drop on October 27, 2008 was followed by an 889.35 increase the next day, and the 2,379.88 drop from October 2, 2008 to October 10, 2008 was followed by a 936.42 increase on October 13, 2008. The S&P 500 index dropped from 931.80 on January 2, 2009 to 683.38 on March 6, 2009 but then recovered to 929.23 on May 8, 2009.
Investment decisions should be based on where you expect the stock market to head in the future, not where it has been in the past. If you believe that there will be more losses in the future, then you should move your money into low risk investments such as cash, certificates of deposit and money market funds. But if you believe that the stock market will start improving soon, you should continue to invest instead of locking in the losses. In times like these the stock market has a tendency to overreact, yielding increased volatility and bigger swings both up and down. After a while the stock market should start settling down and then will start a slow gradual recovery lasting several years.
Parents of college freshmen and sophomores might want to wait a year before taking a distribution from their 529 college savings plans if they believe that the stock market will start improving over the next 12 months. In the meantime they can take advantage of the Hope Scholarship tax credit and use low cost federal education loans to pay for college bills.
[2]
All parents should also review the terms of their 529 plans, especially the fees and other charges. Since 529 plans have limited investment choices, advisor-sold plans with high sales loads and fees have never made sense. The key to maximizing returns is to focus on low-cost direct sold plans that charge low fees. Anything under 1.0% for total fees is reasonable. Also, first look at your own state’s 529 college savings plan if your state is among the 33 states that offer a full or partial state income tax deduction for your contributions to the plan. The value of the state income tax deduction varies from 3.0% to 9.9%, depending on the state and your income tax bracket. Two states, Vermont and Indiana, offer tax credits worth 10% and 20%, respectively.
A Few Words About Trying to "Time" the Stock Market
It is difficult to pick a bottom for the market (so-called “timing the market”) except in hindsight, so it is best to continue making regular monthly contributions to your college savings plan. This gets you the benefit of dollar-cost averaging, which is a particularly good strategy when the stock market is volatile. It buys more shares when prices are low and fewer shares when prices are high. When the stock market is declining, it reduces your average cost per share (“averaging down”), so that your returns will be greater when the stock market recovers. It may feel worse when the stock market is dropping, but dollar-cost averaging buys the same number of shares at a given price regardless of whether the stock market is going down or going up. Focus on longer-term trends, not day-to-day price movements.
What to do About Your Ailing 529
But suppose you’ve had enough and just want to cut your losses. You don’t necessarily need to pull your money out of the 529 college savings plan, as many 529 plans have added more conservative investment options, such as certificates of deposit. You can keep your money within the 529 plan but shift it into a more conservative mix of investments. But if you do want to pull the money out of the plan, you need to consider the tax consequences of such a move. Nonqualified distributions are generally subject to income tax and a 10% tax penalty. However, since 529 plan investments are made with after-tax dollars, these taxes are assessed only on the earnings portion of a distribution, not the principal. If your 529 plan has lost enough money that it is entirely in the red, the distribution will not include any earnings and hence will incur no taxes.
[3] If you liquidate the plan entirely, you may even be able to deduct the losses on your income taxes as an miscellaneous itemized deduction on Schedule A of IRS Form 1040 subject to the 2% of AGI threshold. Unfortunately, you cannot treat a loss on a 529 plan as a capital loss. Also, if you take distributions from more than one 529 college savings plan, you must combine all the distributions before itemizing a loss, so gains in one 529 plan will offset losses in another.
For additional information and advice about saving for college, please visit FinAid’s saving for college section at www.finaid.org/savings/.
[2] Unfortunately, one cannot currently use a distribution from a 529 college savings plan to pay down student loans. However, several members of Congress have proposed amending the definition of a qualified distribution to include qualified education loans, so this may change in the future.
[3] Earnings are assumed to be distributed pro-rata. Relevant citations include 26 USC 529(c)(3)(A), 26 USC 72, and 26 USC 529(c)(6).
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