NEW YORK (Money Magazine) -
Few investors have been hit as hard by the market free fall as parents saving for college. If you were stashing money in stocks, you have been set back two or three years — and you may have only a short time to make up your losses.
To make matters worse, as colleges struggle with shrinking endowments and reduced government support, they are levying steep tuition increases. At already pricey private institutions, tuition increases for the current school year averaged 5.8 percent — far exceeding inflation, not to mention your annual raise.
And among public institutions, where tuition soared an average of 9.6 percent, double-digit hikes were common; the University of Washington at Seattle raised tuition by 16 percent, Texas A&M went up nearly 28 percent for freshmen and transfer students, and costs at Missouri Southern State College skyrocketed 38 percent.
Of course, you always knew college saving would be a challenge, and the fundamentals have not changed, but they have become even more crucial. Here's a six-step checklist to keep you on course. The later steps are particularly relevant to parents of high school students.
Step 1: Measure where you are
It's time to face the truth. Open your account statements and check the state of your savings, then double-check how much more you need to put away to meet the total cost of private or public school; you can use savings calculators on the Web, such as those found at www.collegeboard.com, www.finaid.com or www.money.com.
That's likely to be a big number—even bigger than it was the last time you looked. But stay calm. You can still keep college affordable by putting away at least half the cost, says Dean Knepper, a financial planner in Leesburg, Va., and making up the difference with financial aid and loans.
To find out how much aid you might receive, you can calculate your expected family contribution (EFC), the amount colleges will expect you to pay based on your income and assets; use an EFC calculator at www.collegeboard.com or www.finaid.com or a worksheet in a college planning handbook. If your children are young, you can make only a rough guess, but by the time your oldest is a high school sophomore, you can fine-tune your estimates (see step 4).
Step 2: Review your asset allocation
Think of your college savings as a separate portfolio, either short-term or long-term, depending on your kids' ages. Like any portfolio, its assets should be allocated to deliver the returns you need at a risk level you can tolerate. One danger today for parents of kids still eight or 10 years from college is that the bear market may tempt you to skimp on stocks. We believe that equities are still your best bet for beating long-term college inflation.
On the other hand, if your child is in middle school or high school, you should be reallocating assets into bonds and cash. By the time the first tuition bill comes due, some 80 percent of your money should be in fixed income.
Step 3: Reassess your investing strategy
As we've advised before, if you don't expect to qualify for financial aid, the tax advantages of a Coverdell education savings account (CESA) or a 529 state savings plan are compelling. Several new 529 savings plans were launched in 2002, and a growing number now offer so-called stable-value funds yielding from 2 percent to 5 percent. For more a list of state 529 plans, ?click here.
But if you're certain you'll need financial aid, you're probably better off investing in your own name in tax-efficient mutual funds. The reason: Money saved in CESAs and 529s can count heavily against you under the aid formulas. When you choose funds, watch fees. With returns so low, an extra few basis points in expenses, not to mention hefty sales charges, can erode your college nest egg.
Step 4: Maximize your financial aid eligibility
Aid formulas use your reported income from a base year that incorporates the spring of your child's junior year in high school through the fall of senior year. By reviewing your expected family contribution (EFC) a year or two earlier, you may be able to enhance your eligibility.
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One option: Since the equity you have in your home reduces your aid award under some private college formulas, you can borrow against it to pay credit-card debt. Also, if you're already in your base year and your taxable portfolio has been hit hard, consider taking a loss to reduce income for federal aid purposes.
(We've had questions here at MONEY from investors eager to claim losses on their 529 accounts. There is no clear guidance from the IRS—and there are a few catches. For starters, to claim the loss you must liquidate all 529 accounts set up for that beneficiary in that state. And since the loss is reported as a miscellaneous itemized deduction, it benefits you only if those deductions exceed 2 percent of your adjusted gross income (AGI). You may also run into gift-tax snags or trigger the alternative minimum tax. Claiming the loss may be possible, says accountant Joe Hurley, who heads the Savingforcollege.com Web site, but is it worth the effort?)
Step 5: Make sure your data is consistent
Since most college aid application deadlines fall between January and March, you may have to estimate your 2002 tax numbers on your federal aid application (FAFSA). This year, for the first time, the Education Department will be matching those estimates with the numbers on the returns you actually file with the IRS.
Underreporting your income or assets on your application could cost your child an aid award. So if you correct errors or make changes when you file your tax return, be sure to revise your student aid report right away.
Step 6: Take advantage of bargain-priced loans
Chances are you and your child will have to borrow. Fewer than half of students from families earning more than $100,000 receive any financial aid. Fortunately, federal student loans are a great deal right now. Recent interest rates on Stafford loans were at all-time lows — 3.46 percent for subsidized loans, which are awarded to needier students) and 4.06 percent for unsubsidized.
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You can also get attractive deals on loans — a good thing, since borrowing limits on Staffords are too low to cover high-priced private colleges. Among them: a home-equity loan or line of credit and federal PLUS loans for the parents of undergraduate students.
If you've already taken out PLUS loans, Kalman Chany, author of "Paying for College," notes you can now consolidate at rates as low as 4.88 percent — but given the Federal Reserve's recent actions, education loan rates may drop a bit when they are set in July for the next 12 months.
Prepaid plans -- getting better, but still not risk-free
Market losses in 529 savings plans have many parents looking again at prepaid plans. Now available in 18 states, these plans promise returns on your investment that will equal tuition inflation -- basically you pay today's prices for tomorrow's education.
What's covered: Most plans now allow you to use an amount equal to average in-state costs at out-of-state or private schools. Some also allow you to prepay room, board, books and fees, thus avoiding an unpleasant surprise some years down the road.
Caveat: Every investment has risks. Only seven states officially guarantee that the return on your prepaid investment will be enough to cover future college costs, although others have provisions for unfunded liabilities.