Confront losses in 529 college funds, but carefully

If you've scrimped to save for your child's college education, you might wonder why you ever bothered.

Both stock and bond mutual funds have pillaged so-called 529 college savings plans during the past year and smashed the best of intentions.

Even avoiding stocks and choosing conservative investments hasn't worked in many 529 plans, which are state-run programs that allow people to save for college tax-free. Many plans are geared toward specific ages of students.

Parents with young children don't have the pressure of tuition bills arriving soon, so they can wait out a serious loss and hope that a surge in the stock market will eventually fix the mess.

Chicago-area Financial planner Sid Blum said parents concerned about 529 losses should realize that they do not need all their savings available the day their child starts college. So even a 16-year-old still has six years to allow some of the investments to heal.

But families who want to reap some benefit from the miserable losses might find some solace in a tax strategy.

Joe Hurley, founder of SavingforCollege.com, said that if a 529 plan is worth less now than when money was originally deposited, a family can close the account, withdraw the entire sum and claim the loss for a tax deduction when filling out the forms next year.

But families considering such a strategy must be careful.

The tax benefit is not the same as taking a loss on an investment on stocks, bonds and mutual funds in a taxable account. Rather than falling within the rules on capital gains and losses, the 529 losses would have to be claimed as a miscellaneous deduction on the tax return. That means closing a 529 account would only have value from a tax perspective if the loss on the original investment exceeded 2 percent of a person's adjusted gross income.

It would apply only if people itemize on their tax return. In addition, large miscellaneous deductions can trigger costly bills through the alternative minimum tax (AMT). Hurley suggests that before closing a 529, people check their vulnerability to the AMT by using last year's IRS Form 6251 to do a calculation. If the deduction would throw you into the AMT, it probably is not worth it.

Parents who have a child in college or about to start next fall might want to insulate a year of tuition from both the stock and bond market now, because of the uncertainties in the markets, said financial planner Gary Bowyer.

Outside of a 529 plan, certificates of deposit would work. Inside a 529 plan, a money-market fund would be a stable choice.