The New Reality Of College Savings

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OCEAN CITY – In 2008, the total value of the money kept in college savings plans in the U.S. dropped 21 percent, to $88.5 billion from $111.9 billion, while the cost of tuition at a four-year public college rose by 5.7 percent.

You don’t need an MBA to understand the significance of these facts placed side by side. Whether you’re just starting to save for college or are well along, you may be counting on a college savings plan to fund your child’s higher education. And you might now be wondering whether you will be able to cover the needed costs — or even, if the student is close to college age, how you’re going to recover the financial ground your plan may have recently lost. There are several strategies that can help you adapt to the new economic reality, but you need to align them with your savings target and time horizon.

Here’s how to make smart changes to your plan.

– Adapt your strategy to your child’s age: So, what if you’ve been putting money into a child’s education plan and have seen losses? To begin with, if a child is more than four years from college, don’t panic — your portfolio has some time to recover, says Chuck Toth, Merrill Lynch’s Director of Product Management for Personal Retirement. But you will probably want to make some adjustments to your asset allocation to see to it that the savings plan continues to be aligned with your financial target and time horizon.

For instance, no matter how risk averse you may be feeling as a result of the recent volatility, it may be necessary to place a greater emphasis on growth. The good news is that the Internal Revenue Service recently made it easier for investors to reallocate within their 529 plans. For 2009, the IRS will permit two annual investment modifications to these accounts, which is one more than in previous years.

Consider sticking with stocks to keep up with college inflation: Meanwhile, despite the nature of the current economic crisis, if your child is a number of years from college, Toth believes it is important that you keep your 529 plans invested in the equities markets. If you’re just starting out on the road to college savings, the idea is to remain as broadly diversified as possible, says Toth. The reason? The soaring price of schools. “The rate of inflation for college tuition has been rising at several times the rate at which salaries have risen,” he notes.

To be fully diversified, Toth considers it critical to maintain a healthy exposure to a broad range of investments across the broadest possible range of sectors and asset classes. Just how much of your college portfolio should be in equities? It depends on your risk tolerance and the age of the beneficiary. If the beneficiary is more than 10 years from college, Toth recommends devoting a large percentage of the portfolio to equities, as you focus on growth. But as your student enters high school, you should consider making a gradual shift toward a heavier proportion of fixed income and cash investments.

Keep your 529 college savings plan at the heart of your strategy: Even with the recent market weakness, basing a college savings strategy around a 529 plan continues to make the most sense, according to Toth. That’s because its broad access to various investment options makes diversification easier, and also because of the high funding limits — with tax-deferred growth and other state tax benefits applying in many states.

Depending on your needs, other savings and investment vehicles can help you meet your goals. One way to supplement a 529 plan is with the Coverdell Education Savings Account, which offers broad investment choices including stocks, bonds and mutual funds. Withdrawals from the ESA can be used to pay for K-12 school expenses in addition to college costs.

Some parents facing losses in their children’s college savings accounts might be considering borrowing from a 401(k) or diverting other retirement savings to college payments, especially if the need is imminent. Toth strongly advises against that idea.

“It could mean setting yourself up for bigger financial problems down the road. Paying for college with retirement savings makes it much harder to fund your retirement,” he said. For one thing, any money that you take out of your retirement savings is no longer working in the market for you — and that’s a loss you can’t make up. In addition, if you are terminated or laid off, some 401(k) providers may require you to either pay back the entire loan or to claim it as a plan distribution.

Instead, Toth recommends making college savings and retirement planning part of the same conversation with a financial advisor, who can model a variety of scenarios that take into account the funding of both. Also consider making college savings an extended family discussion by bringing your children and their grandparents into the conversation as early as possible.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)

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