Saving for College in a Tough Economy (page 2)

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.

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/.

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