Ask Liz Weston

To encourage participation in state-run 529 plans, the College Savings Plans Network  has declared today to be “529 College Savings Day.” They’ve got an uphill battle to promote their cause.

529 college savings plans have been under fire lately, some for good reason. Those run by Oppenheimer Funds, for example, had a too-aggressive asset allocation for students approaching college, leading to big losses. Oppenheimer also had big investments in bond funds that blew up.

That doesn’t mean you should give up on this tax-advantaged way to save for college–far from it. But you also shouldn’t invest in a 529 blindly. Here’s what parents need to know about saving for college:

Retirement has to come first. You’ve heard it before: your kids can get loans for school; nobody’s going to lend you money for retirement. However:

If you can save for college, you probably should. The more money you make, the more of your income and assets a college is going to expect you to contribute toward your child’s education. Saving early and often will help soften the shock of your “expected family contribution” and reduce the amount of debt your child may need to take on.

Don’t save in your child’s name. Custodial accounts (UGMA, UTMAs) get killed in financial aid formulas. 529s get much better treatment. Another option is to use retirement accounts, which typically don’t get factored into aid formulas, but only consider this is you’re already saving way more for retirement than you’ll actually need. Tapping your home equity should be thought of as a last resort, not your primary college funding plan. Savings is always better than debt.

529 college savings plans are a good option for many families. Withdrawals are tax-free when used for qualified education expenses, a big benefit for those in the 25% federal tax bracket. If your kids are within 5 years of college, though, the tax benefit starts to diminish: your expected returns aren’t likely to be big enough for the tax break to matter that much, and you have to put up with some restrictions on how you use the money. So if your kids are already in high school when you start saving, consider doing so in a regular taxable brokerage or bank account.

When in doubt, go with Vanguard. Vanguard’s famous for its low fees and its index-based approach to investing that aims to match, rather than beat, the markets. The Utah Educational Savings Plan Trust is a Vanguard-run option that’s Morningstar consistently names as one of the five best in the country.

Back before our daughter could even talk, I wrote a column called “Stop your kids’ whining” that was all about short-circuiting kidlet nagging and teaching them valuable lessons about money.

Oh, what I didn’t know.

Actually, in hindsight, the advice holds up pretty well, mainly because I relied on money-smart parents like Janet Bodnar, now editor of Kiplinger’s magazine, and Steve Rhode, the Get Out of Debt guy.

But kids’ appreciation and understanding of money constantly evolves, so I’m always on the lookout for more great advice and ideas. Here are a few good blog posts on kids and money that I’ve run across recently and that I hope you’ll enjoy:

• Bargain Babe has frugal summer activities for kids.
• Why Moolanomy advises “Never say ‘we can’t afford it.’ “
• CitySpur offers “10 tips on how to explain money problems to your preschooler” that work for older kids, too.
• BeingFrugal.net explains “How I taught my preschooler the value of a dollar” (and also gets some great suggestions from readers on end-of-the-school-year presents in “You tell me: Teacher gifts“).

And here are my “5 money lessons for preschoolers” and Melinda Fulmer’s segmented-by-age “What kids need to know about money.”

Dear Liz: I’ve been contributing to a traditional individual retirement account for the last few years. Taking one of your recommendations, I would like to move the money to a Roth IRA. I understand that I’ll have to pay taxes on the conversion, but will there also be any penalties involved? If so, how much of a penalty? If there is no penalty and only taxes, what is the rate I should be expecting?

Answer: Roth IRAs offer tax-free withdrawals in retirement, which is why they’re a great deal for many savers, and conversions are about to become easier.

Currently there is no penalty for converting a traditional IRA to a Roth, but you will owe income taxes that are determined by your tax bracket. If you’re in the 25% federal tax bracket, for example, you’ll owe taxes equal to 25% of the amount you convert, assuming your contributions were all tax-deductible. (If you made nondeductible contributions, those will reduce the tax bill proportionately.) You’ll also need to factor in state and local income taxes.

You can convert to a Roth this year only if your modified adjustable gross income is $100,000 or less. Next year, however, the income limit on Roth conversions is scheduled to be removed. Also, for 2010 only, you can opt to have the taxable income from your conversion reported in two equal installments in 2011 and 2012, putting off the tax bill you owe.

Make sure you have enough cash to cover the taxes without raiding the IRA you’ll be converting. But being able to put off the tax bill, and paying it over two years, should lessen the burden. Talk to your tax pro for details.

Dear Liz: This is regarding your advice to the would-be business major who was accepted at her dream college but who wasn’t offered much financial aid. I was dismayed that you suggested trading down without even knowing which college accepted her. If indeed she got into an Ivy League school, she would be crazy to give up the opportunity. If she is capable, she will be earning millions over a 40-year career. The $200,000 cost of her school would be a drop in the bucket compared with that. The top-tier schools in reality provide more opportunities for both graduate school and career advancement. It is all about “option value,” and these schools provide the greatest upside.

Answer: You may be overestimating the value of an Ivy League education. You’re certainly underestimating the risk of shouldering $200,000 in loans for an undergraduate degree.

A study by a Princeton economist found that those who are accepted at Ivy League schools, but who opt to study elsewhere, do just as well in life as those who graduate from top-tier schools.

If she stuck with her dream school, our student would quickly exhaust the low, fixed-rate federal student loans available to her. The maximum she could borrow under federal student loan programs would be $31,000. That means she would need to turn to private student loans, which tend to have variable rates that currently average around 12% and which have no caps.

Using private student loans to finance an education is equivalent to using credit cards — except unlike credit card debt, student loan debt generally can’t be erased in Bankruptcy Court.

A wiser course for this business major might be to find a more affordable undergraduate education and then seek out a brand-name MBA program. The return on that investment probably would be high enough to justify the cost.

Dear Liz: You recently stated that the latest FICO credit-scoring formula, FICO 08, excludes collections under $100. Not so. My 820 credit score was recently dinged by a $65 collection. It dropped my score over 100 points and took me a lot of time to get it removed.

Answer: Not every lender uses FICO 08. When a new version of the FICO formula is rolled out, some lenders adopt it immediately while others may take month or years, or may never do so at all.

The bureaus only started offering FICO 08 to lenders this year, so it’s rather likely that many lenders will still be using the older versions to calculate your scores.

Loan limits for so-called jumbo conforming mortgages have been increased back to $729,750 for the highest-cost areas. That could be good news for home buyers in expensive cities and for homeowners with some equity who’ve been wanting to refinance but who’ve been dismayed at the persistently-higher rates on big loans.

If you need all that translated, here’s the scoop. The dividing line for mortgages used to be $417,000, with loans below that amount eligible to be sold to the big mortgage agencies (Fannie Mae and Freddie Mac) as “conforming” loans.

Mortgages above that limit were considered “jumbo” loans and typically came with a somewhat higher interest rate. “Somewhat” began “much, much” when the credit crisis hit and investors shied away from the big loans they used to gobble with relish. So Congress stepped in by temporarily raising the conforming limit for high-cost areas (think LA, NYC, SF) to $729,750.

That limit dropped to $625,500 at the start of the year, but has now been restored. Interest rates on these “jumbo-conforming” loans with one point (a fee equal to 1% of the loan) have been running about half a percentage point more than regular conforming loans, according to mortgage expert Dick Lepre of LoanMine.com.

“The way these have been priced there is not an attractive no-point loan so the best deals are with one point,” Lepre recently wrote in his newsletter. “Add in the other closing costs [and we] are talking maybe $8,000- $10,000 in costs. To see if this makes sense add that amount to your loan balance and compare the payment to your present one.”

Lepre advises that there are two new restrictions on cash-out refinancing, for those who want to borrow more than their current loan amount (to pay off a HELOC balance, for example):

• You can’t borrow more than 60% of the home’s current appraised value for a cash-out and
• Your middle credit score must be at least 740

These rules apply only to cash-outs, Lepre notes, and just financing the loan fees doesn’t count as a cash-out.

For more about mortgages, read:

• 6  mortgage rip-offs to avoid
• 8 big mortgage mistakes and how to avoid them
• The 3 worst reasons to buy a home

Some interesting stats emerged from Hewitt’s latest report on 401(k) savings and investing habits of more than 2.7 million employees. Mostly, the report shows our investing habits haven’t changed all that much. Why? Some say inertia (who knows what to do), while others say some employees continue to hold faith in slowly building their 401(k)s over time.

No matter what, “the losses workers have sustained are so extraordinary, they’ll need to be much more proactive about saving to build their nest egg back up to pre-recession levels,” says Pamela Hess, director of retirement research at Hewitt Associates.

Here are some of the study’s key findings:

• The median rate of return in 2008 for 401(k) plans was a 28.3% loss—with the average 401(k) balance dropping from $79,600 in 2007 to $57,200 at the end of last year.
• Only 11% of employees were able to break even or gain in their 401(k) portfolios. Forty-four percent of employees lost 30% or more of their savings in 2008.
• 74% of employees participated in their 401(k) plan in 2008, which is consistent with previous years’ findings.
• The average 401(k) contribution rate dropped only marginally, from 7.7% in 2007 to 7.4% in 2008. Just 5% stopped contributing to their 401(k) plan altogether in 2008.
• There was a slight increase in the number of workers who made any trade in their 401(k) plan last year: 19.6% in 2008 vs. 18.7% in 2007.
• Nine of the ten most active trading days were the day after a large downturn in the market, or days with an average return of -4%.
• Employees’ average equity exposure dropped to just 59% in 2008—which is an all-time low since Hewitt began tracking it in 1997. Stable-value funds—which are considered less risky investments—experienced an 11% increase in asset allocation in 2008.
• 18% of employees took a hardship withdrawal from their 401(k) plan in 2008. The number of employees taking out 401(k) loans (23.1%) in 2008 remained similar to levels in prior years.

For more advice of investing, check out my columns below:

• 5 life lessons from the recession
  

• Under 35? Hurray for the meltdown!

• What’s the best way to reduce risk as I approach retirement?

How quickly we might forget. A new survey by HSBC Direct shows that 76% of those polled will probably return to their old money habits once financial conditions improve.

Currently, Americans have returned to some good financial habits during the recession, including:

• 81% are saving more or the same than they were six months ago
• More than half have reduced discretionary purchases, and nearly half have cut back on household spending
• 71% of people feel either an equivalent or increased sense of financial control than they did six months ago

But according to the survey, which polled 1,000 respondents online on April 14 and 15, these habits might not stick or develop further once the financial crunch eases. (Survey’s error of margin is +/-3.1%):

• One in four admit to not having a specific savings strategy
• 15% say it took significant debt or bankruptcy to get them to save at all
• Half don’t thoroughly research all the financial products they purchase
• 44% don’t consider themselves as knowing enough about personal finances to “get by”
• 43% have saved money on and off, but never followed a consistent plan
• One in four admit to not having a specific savings strategy, and 15% say it took significant debt or bankruptcy to get them to save at all
• Only 12% have instituted an actual budget

If history is any indication – ahem the dot.com bust in the stock market in 2001 comes to mind – then it doesn’t take consumers all that long to forget.

Don’t repeat history. Check out my columns for the latest financial news to help you get back — and stay — on track:

• 7 guides to fixing your finances

• The 100 most useful Web sites

• Organize your financial life

If you’ve still got a job, some money in the bank and your other financial plans are on track–you’re saving for retirement, paying down debt–you should seriously consider a real summer vacation this year. Here’s why:

Staycations don’t work. Staying home may save money, but it won’t provide the break you need to relax and “sharpen the saw.” For that, you need a change of scenery. Otherwise, you’ll spend a good chunk of your time being constantly reminded of all the things you “should” be doing (“I really should clean that closet. The hallway needs a coat of paint. When am I going to take that load of clothes to the Goodwill?”)

The deals are amazing. The recession is forcing hotels, airlines and restaurants to cut prices. Some of the most impressive deals are at the higher end, making it easier to upgrade to a more swank experience if you want. Shop for 4- and 5-star hotels at Hotwire or Priceline; the savings can be tremendous and you’re guaranteed a decent place to sleep. Sign up for email updates from your favorite airlines and hotel chains to get first crack at the deals. Also, if you have kids, check out KidsEatFree.com for child-friendly restaurant deals in all 50 states.

It’s easier to use points and miles. Fewer travelers mean more opportunities to score airplane seats and hotel rooms with your frequent traveler programs. Since these programs are constantly being changed and watered down, you’re smart to use your rewards as you accumulate them rather than wait and see them devalued.

Memories matter. Studies about what makes us happy agree: experiences matter more than stuff. Making memories with family and friends can be an investment that offers lifelong returns. So go visit your college roommate or your Aunt Zelda or take the kids fishing.

Travel can make you a better person. Not every trip to every place, of course, but if you take time to appreciate a new place and its residents, the experience will change you–make you smarter, wiser, more understanding.

So pack up.

Afternoon update: If you are sticking close to home, check out this excellent Trent Hamm post: “10 resources to find cheap or free summer fun.”

If you’re worried you might lose your job and won’t be able to pay your bills, the idea of a credit-card protection plan sounds great. But think twice and read the fine print before signing up. You could do better on your own.

In general, these plans advertise that if you have a hardship – lose your job, have a death in the family –  it will freeze your account so it stops interest accrual and the minimum payment made until you’re able to work again.

But nothing is free, and these plans are costly. In the end, the credit-card company wants to be paid. And you need to understand that no one will just wave a wand and absolve you of your debt. You will have to repay it — and with their fees under these plans.

The cost of the purchase protection varies by carrier. It ranges from $0.50-$0.99 per $100 that you carry as a balance. If your balance is $10,000, the protection plan could cost almost $100 per month or $1,200 per year, says Bill Hardekopf, CEO of www.lowcards.com.

“If you carry a balance on your credit card, the monthly cost of the plan is added to your balance and you have to pay interest on it,” Hardekopf says. “These plans are another way for issuers to increase their revenue.”

Since the plan will only cover your minimum payments, why not put the money you would pay for the plan toward your current bills, he suggests.

Here are some other tips from Hardekopf, also author of The Credit Card Guidebook:

• If you already have life insurance, that plan may cover your debts after death.
• Contact your issuer and try to work out a payment plan yourself.
• If you are currently unemployed, are you eligible? Most issuers require that you be employed for 30-90 days before enrolling, and you must be a full-time employee.
• Are you close to your credit limit, or have a history of late payments on your card? You may not be eligible.
• Credit card protection plans don’t follow the same rules as traditional insurance. It is the consumer’s responsibility to be familiar with the requirements and exclusions of these plans.
• Look for time limits and exclusions. Payment periods vary by the reason you need them.
• Examine the age requirements since many have a maximum age limit.
• Ask the issuer what situations will it pay for? What situations aren’t covered?
• Will the plan cover your spouse or supplementary cardholders?
• What happens if you miss a payment or if your account isn’t in good standing when you file a claim?
• How and when can the policy be canceled?

And check out my columns on how to get the best from your plastic:

• Credit cards with the happiest users

• 9 big credit card myths

• Don’t use 401-(k)s to pay off credit cards