College fund blues

(Fortune Magazine) -- Last April, anticipating the first tuition check she'd be writing to the University of Puget Sound, Kathryn Pett shifted her 18-year-old daughter's 529 college savings plan out of stocks and into the equivalent of a money market fund. Boy, is she glad she did. Since then the equity portions of those state-sponsored plans, where your after-tax contributions grow tax-free, have crashed along with the rest of the market.

But Pett hasn't escaped the downturn entirely. She still has stock-heavy 529s for her 7- and 8-year-old sons. "I don't know how much they're down," says the Salt Lake City attorney. "I haven't wanted to look."

Maybe it's time to open that envelope. While the stock market isn't likely to bounce back quickly, parents can take advantage of some smart strategies for getting the most out of their 529s in the long run.

As the stock market swooned in October, many investors piled into the most conservative options offered by 529s - money markets, certificates of deposit, stable-value funds. But even if you're war-weary, it might not make sense to abandon stocks. Nationally the cost of tuition has risen at roughly twice the rate of inflation. Investing your savings in low-yielding T-bills won't be adequate to meet future obligations.

One option for the nervous is to leave your current balances where they are and allocate any new contributions to cash equivalents. While 529s let you switch how your existing money is invested just once a year, in most plans you can redirect new deposits at any time. If the market starts to rebound, you can quickly start adding to your stock stake again.

Not everyone, of course, is so gun-shy. In fact, some people think the market is cheap and now is the right time to buy big. As Lynne Ward, director of Utah's 529, has watched investors decamp into the plan's cash-like option, she's also noticed a handful of investors moving large blocks of money into the S&P 500 index fund. "Some people," she says, "are buying low."

If that's what your brain is telling you to do, but your heart is still palpitating from the last drop in the Dow, one strategy is good old dollar-cost averaging. By investing a fixed amount at regular intervals, you can help insulate your portfolio from sudden dramatic falls in the stock market because more shares get purchased when prices are low, and fewer shares get bought when prices are high.

With most 529s it's easy enough to set up an automatic withdrawal from your bank account - a $200-a-month debit is less jarring than a $2,400 check on Jan. 1.

The bulk of 529 funds are kept in "age-based" portfolios, which are designed to tack more toward bonds as your kids get closer to college. That makes sense. But different plans have different ideas about how that should shake out.

Joseph Hurley, founder of Bankrate's Savingforcollege.com, a site that compares 529s, analyzed dozens of plans and found the stock exposure for students on the cusp of college ranged from zero to 75%. Make sure your plan fits your tolerance for risk.

Most parents would be horrified to learn that three-quarters of their college savings were in stocks just as Junior's going to need the money. Age-based portfolios may seem like a no-brainer, but "you still have to manage your money," says fee-only financial planner Fred Amrein of Wynnewood, Pa.

If you prefer more certainty in these turbulent times, consider a prepaid-tuition plan offered by your state. If you pay the price of tuition today - in a lump sum or in monthly installments - you will be covered for the cost of tuition at your state college or university when your child is ready to attend.

While not as sexy as investment accounts, state-run prepaid plans do help hedge against tuition inflation without all the market risk. The downside is as it always has been: You have to commit years in advance to your kid's going to a state school.

If that's not to your choosing, you might instead opt for the TIAA-CREF-run Independent 529, which sells tuition credits for 274 private universities. But again, unless you're willing to tell your child your savings can help pay for Princeton but not Yale, it's a gamble.

Some parents, fed up with poor performance and limited investment options, have considered closing their 529 plans. The consequences can be harsh. Unless you're lucky - lucky? - enough to have a portfolio that's underwater, you'll need to pay federal income tax and a 10% penalty on any gains. And besides, where else can you find an investment vehicle that lets your savings grow tax-free?