When times are tough -- and times are undeniably tough -- it's easy to lose faith in the potential of the financial markets. People have told me they're not going to fund their IRAs this year, and I recently got a letter from someone wondering about the wisdom of 529 accounts for her kids given "the downward slide of the market." She was considering staying in cash or investing in Treasuries.

I understand investor fear and the reluctance to commit new money to the stock market given recent declines. But I also believe that what's going on in the markets today doesn't change the utility of 529 accounts for most investors.

529s: The Basics

First, realize that 529s are simply tax-advantaged accounts designed to encourage people to save for a child's college education. Their power lies primarily in the fact that they offer tax-deferred growth; in fact, all investment income generated in the account is tax-free as long as the proceeds are used for "qualified education expenses" (tuition, room and board, books and other expenses; the full details can be found in IRS Publication 970 at http://www.irs.gov). The risk of a 529 lies not in the account structure but the investments it contains -- which I'll discuss in more detail below.

Before you choose investments, though, you have to choose between two types of 529 plans: prepaid and savings. Prepaid plans allow you to pay future tuition at today's prices. Since higher education costs have been rising faster than inflation, this sounds like a good deal, but they're difficult to recommend. Most prepaid plans lock you into your state's public system of higher education (or even into a specific college), and they generally don't cover ancillary expenses. Savings plans are much more flexible. You choose how to invest the funds in a small spectrum of investment opportunities, and you can use the proceeds for qualified higher education expenses at any accredited college or university.

The tax deferral makes 529 plans much more attractive than keeping an equivalent amount of money in your own name or a custodial account. (And be sure to check to see if you qualify for a state tax benefit in addition to the federal deduction by investing in your state's plan.) But there's another benefit: 529 plan assets are considered assets of the parents, not the child, when it comes to financial aid. Assets of the child -- like a custodial account -- are "taxed" more heavily when aid decisions are being made. Moreover, parents can put quite a lot of money into 529 accounts without triggering gift taxes: up to $65,000 over five years (or $130,000 for a married couple) and up to $300,000 in total in some states. The 529 assets can be transferred to other children or relatives without penalty. And they're not just for parents; anyone can open a 529 plan for a child (listen up, grandparents!).

Investment Choices

So I think a strong case can be made for using the 529 plans as a tool for college savings. The real question for the woman who wrote to me is how aggressive to be with the money. Sure, it's hard to plow money into a fund or funds when the markets have declined (though that could ultimately be a good thing: buying stocks when prices are down). But long-term investors need to keep their time horizon in mind. If her kids were only a few years from matriculation, I would suggest conservative investments. But if they're quite young, I'd suggest a more aggressive approach. Just as you would do with any other account, you have to balance risk and reward, making adjustments as you approach your investment goal. (And always realize that like any investment, it's possible to lose money by investing in a 529 plan.) Continued...