Bear market shouldn't scare 529 savers

09/15/2008

QUESTION:
Dear Joe,

We opened a 529 plan for my daughter when she was 1, and have put in a total of $5,000. We have watched it dwindle down to just over $4,000. Since then, we haven't added to it and she is almost 2.

We have more to add to her college fund, but are afraid to put our money where it seems to be losing.

Should we continue to put her college fund in the 529 plan? Or should we just put it elsewhere until the market improves? If the answer is to go elsewhere, then where?

-- New Mom

ANSWER:
Dear New Mom,

Many investors are feeling your pain. Whether it's their 529 accounts, 401(k) plans, IRAs or neighborhood investment clubs, they've seen account values drop over the past year and are wondering what to do about it.

The right answer may be to do nothing.

Your child is not yet 2 years old, which means the college savings account has plenty of time to recover before you begin withdrawing funds to pay college bills.

History is no guarantee, but strongly suggests that an investment account weighted more heavily in stocks will perform better through market cycles than one that stays with money market funds or other "safe" investments.

At the beginning of this decade, many 529 plan participants were feeling just as you do now. The Dow Jones industrial average suffered three straight losing years from 2000 to 2002, and in 2002 alone the index shed 16.76 percent of its value to close at 8,341.63.

Fast forward to September 2008. As the month opened, the Dow Jones industrial average stood at 11,543.55, representing a 38 percent gain from the end of 2002, in spite of its 1,814 point (13.6 percent) loss over the previous 12 months. College savers who exited the stock market at the end of 2002 are probably not doing as well as those who stuck with it (although perhaps they sleep better).

Although you don't say, it's likely you selected an age- or matriculation-based investment option in your 529 plan. These options are specially designed for college, starting out mostly in stocks when your beneficiary is young and automatically shifting to fixed-income and principal-guaranteed investments as she nears college age.

To me, the age-based option makes a lot of sense, even when you are forced to accept the higher risk of the market while your child is young.

If you decide to stay away from the stock market with the additional money you're ready to set aside for your daughter's college savings, you can still find excellent low-risk options in many 529 plans. Such low-risk options include money market funds, principal-guaranteed products, bank certificates of deposit and inflation-protected securities.

Later on, you can switch to another investment option if you decide you want to take on more risk. Switching to a different investment option in your 529 plan is permitted one time per calendar year. A few 529 plans allow for dollar-cost averaging from their money market option into equity-weighted options. These transfers do not count against your once-per-calendar-year investment change.

With your account currently in a loss position, you could decide to liquidate it and claim a miscellaneous itemized deduction on your tax return. But first, check with your tax professional. Miscellaneous itemized deductions provide no benefit unless they exceed 2 percent of your adjusted gross income.

If you can get a tax benefit, be sure to wait 61 days before re-contributing the proceeds to

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