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The 411 on 529s

Navigating college savings plans can be treacherous. Here’s how to avoid the hazards. (2006)

 

By Charlotte Huff

Did your little darling just start to walk? Punch a few figures into collegeboard.com, just one of numerous calculators online, and you’ll soon be staring at a four-year price tag that starts at $127,000 for a public university, including room and board, and climbs to $273,000 if Hank or Hannah opts for private instead.

Worse, those figures optimistically assume costs will inflate only 5 percent annually — over the last three years, college price tags have compounded by 5.7 percent per year at private schools and 6.6 percent to 9.8 percent at public ones.

But we’re not here just to spotlight depressing problems. Of course, a savings strategy (combined with begging for scholarships) is mandatory, and that’s where 529 plans come in. Not-so-sexy name notwithstanding, these plans have attracted droves of devotees since a 2001 tax change allowed educational investments to be withdrawn tax-free. By early 2006, investments in 529s totaled an estimated $75 billion, according to the nonprofit College Savings Foundation. And the Financial Research Corporation, a Boston consulting firm, estimates that 6.5 million Americans hold at least one 529 savings account.

They’re not popular for nothing: These plans can be among the best vehicles for college savings.

But the 529 landscape can also be a quagmire of confusion, where it’s easy to stumble into a plan rife with hefty fees.

The good news is you can avoid the pitfalls, says Michael Steiner, wealth manager at RegentAtlantic Capital, a New Jersey-based financial planning firm. “There are plenty of low-cost plans that offer a fair amount of diversification,” he says. “It’s a matter of doing your homework.”

By 2006, there were more than 80 state-sponsored 529 plans, according to NASD (formerly known as the National Association of Securities Dealers), with investment options ranging from stock-heavy portfolios to a more conservative stock-bond mix. Shares in some plans must be purchased through a broker. Others can be bought directly, with the help of a wealth of information online. 

Many of today’s 529 investors are likely wealthy, with a financial adviser on speed dial, says Peter Breen, chief strategist for BetterInvesting, a nonprofit organization that educates investors.

Unfortunately, 529s remain too much of a mystery to the average investor who wants to jump-start college savings, he says: “The audience that truly needs a 529 doesn’t truly understand it.”

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Investors are able to invest far more money in a 529 than in a Roth fund or another educational fund, called the Coverdell Education Savings Account. If you can swing it, you can salt away a lump sum of as much as $55,000 per child every five years without paying any federal gift tax. Plus, many states offer tax deductions on contributions.

The money can be used for a wide variety of educational costs, including living expenses and books, and any unused funds can be rolled over to another child. (Money withdrawn for noneducational purposes incurs a penalty.) The fund remains under the parent or contributor’s control, which means your child can’t cash it out to hike across Europe.

“When they turn 18, I hope they are mature enough, moneywise,” says Tina Corral of Phoenix, who’s opened 529 accounts for both of her children, ages 5 and 3. “But if they are not, I don’t want them to run through that money. I want control over that.”

The trick is making sure your long-term investment gains aren’t eroded by high fees. The funds usually have several layers of fees, including typical mutual fund management fees and state plan administration fees. A broker will charge fees as well. The array of costs can be so confusing, it’s attracted the attention of Congress, which held hearings about the fees in recent years. The NASD now has a blunt warning online, which states that investors should shop carefully for a plan that won’t shortchange them.

“The trend has been toward lower fees and clearer disclosures,” says Kerry O’Boyle, a mutual fund analyst at Morningstar, a Chicago-based financial research company that publishes an annual list of best and worst 529 plans based on fees and investment options.

Even so, O’Boyle says, “there are a good number of plans that are still mediocre to poor just because of overall fees and limited flexibility.”

Meanwhile, that federal tax freebie could be in jeopardy. Although 529 plans won’t go away, their tax-free status will expire at the end of 2010 if Congress doesn’t take action. Steiner and others predict it will. Worst-case scenario, Steiner says, qualified 529 distributions would be taxed in the college student’s tax bracket, likely much lower than your own.

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Most Americans use a broker to purchase a 529; roughly 80 percent of plan assets were invested that way in 2005, according to the Financial Research Corporation. With some legwork, individual investors can make smart investment decisions on their own, says David Pearlman, senior vice president of Fidelity Investments and chairman of the College Savings Foundation. “[But] there are a lot more people who don’t have the time to learn everything or don’t have the confidence to do it,” he says. “That’s what they are paying a broker for — education and advice.”

Marilyn Wilson Lund, a California resident, purchased a Rhode Island fund shortly after her daughter’s birth in 2002. Her family’s trusted broker had researched various options before recommending it, says Lund, chief executive of the educational company Nurturing Results. “We like to look at the whole thing as a portfolio, so we have a tendency to do investments through him,” she says.

The question — a subject of some fierce debate — is whether the typical middle-income investor, with a 401(k) and a newly opened 529 plan, should invest in broker advice. If your annual 529 contributions aren’t big enough, broker fees can consume nearly all your investment gains, says Raquel Meyer Alexander, an assistant professor of accountancy at the University of Kansas who has extensively researched 529 plans.

For the average investor without complex investment portfolios to manage, the best choice might be your own state’s plan, she says.

“Buy the state’s index fund — there are some very low fees,” she says. “Let it ride until your child goes to school. You don’t need an actively managed 529 plan unless you are a multimillionaire.”

Alexander, working with LeAnn Luna at the University of Tennessee, has scrutinized 529 plan investments, identifying some surprising patterns in a study published in 2005 by the Journal of the American Taxation Association. Their study, which analyzed 77 plans totaling $45 billion in assets, found that higher-fee plans were attracting more investment than lower-fee plans. States with the most beneficial in-state tax deductions also had the lowest investment rates, the study showed.

So what’s considered a high 529 fee? If you purchase an actively managed fund from a broker, a good rule of thumb is to keep your combined fees — state, plan, distribution — below 1.25 percent, Morningstar’s O’Boyle recommends. When you directly invest, your fees should fall below 1 percent.

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Uncertain where to start? If you pay state income tax, you won’t go wrong by scrutinizing your home court first.

About 30 states offer deductions and tax credits, according to the NASD. Most limit the amount of the state deduction allowed each year. A handful of states, including Colorado and New Mexico, are quite generous, with unlimited state tax deductions, Alexander says.

As with so many 529 details, though, the headaches lie in the fine print. Morningstar’s annual analysis, published in its February 2006 newsletter, gives Alaska T. Rowe Price College Savings Plan and Utah Educational Savings Plan Trust high marks. But Morningstar also describes a sometimes surprising variety within certain states’ plans. Nebraska, for example, has a plan on both the best list and the worst list.

As you research plans, don’t be afraid to ask tough questions, says BetterInvesting’s Breen. Or, he stresses, the stupid questions: “Admit that you don’t know what you don’t know.”

Above all, don’t allow any intimidation you feel to morph into lethargy about investing for college, he says. “The importance of starting today cannot be overemphasized enough,” Breen says.

If you’re really careful, your 529 can repay the time and effort, and then some. And if you’re really lucky, your child will pay you back one day — with a fat scholarship to augment it.