by Cynthia Harrington
College didn’t get much more expensive over the past two years, but the assets in the state savings plans jumped by 87 percent in the first quarter of 2004, to $40 billion versus the prior-year quarter. The 2002 aggregate of $20 billion represented a 100 percent rise from the year before.
Advisors site several reasons behind the growth. Not only are parents motivated by the tax-efficient way to save and to pay for higher education, but grandparents use 529s for estate planning purposes and some investors even use the 529 in their own retirement saving plans. Add to that the improvements in the plans, and the list of reasons for the growth is complete.
“These are excellent little vehicles,” said Chris Frederiksen, CPA, of Client Wealthcare, in Mill Valley, Calif. “With an estimated $200,000 due for college expenses for a child born today, it’s easy to see the real advantage of the 529 plans.”
All 50 states and the District of Columbia have established plans. Each state’s plan offers different features, but all share a federal tax deduction on contributions and tax-free withdrawals for education. Frederiksen, whose company also runs seminars for CPAs on how to start offering financial services, likens the 529 plans to an IRA. “The owner calls the shots and has continued access to the money,” says Frederiksen. “If they take it out for a non-education reason they just pay the tax and the 10 percent penalty.”
The plans and the media do their part to tell investors about the advantages. “Clients are far more familiar with the 529 plans and are excited about them,” said Kathy Stepp, CPA, PFS, CFP and principal of Stepp & Rothwell, in Overland Park, Kan. “It’s clear we’re getting to the point where everyone will have a 529 plan.”
A confusing patchwork
The complexity of the industry keeps advisors busy. Each state sports different features as well as choices for asset management. Some states like Missouri grant state income tax deductions, as well as honoring the federal deduction on contributions and distributions. Contrast that with Illinois, which allows the state tax deduction on contributions but nicks out of state 529 plan holders the federal tax on distributions.
For Stepp, the primary consideration is the status of the underlying investment vehicles. “We like the Kansas plan for one major reason,” she says. “The investments are transparent, so while these may not be our favorite mutual funds, at least we know what it is we’re buying.”
Some plans offer only generic-sounding funds. There might be a bond fund, a stock fund or a hybrid fund. “Those states have gone the same route as the 401(k)s when they first came out,” said Stepp. “We don’t like them because we can’t see who’s managing them and how.”
In addition to the complaint of a lack of transparency of investment choices in some states’ plans, high fees and costs trouble some. Some states charge account set-up and maintenance fees. On top of that, the asset managers’ fees vary widely. Sidney Blum, CPA/PFS, CFP, ChFC and director of financial advisory at Leonetti & Associates, in Buffalo Grove, Ill., considers only those plans with the lowest cost asset managers.
“We start by looking for plans managed by T. Rowe Price, Vanguard or TIAA-CREF,” said Blum. “The bottom line on these plans is what the account holder will gain. Over the long run, just a few extra basis points a year can add up to tens of thousands of dollars’ difference.”
The nuances of each state’s plans then come into play. A state tax deduction for in-state plans might be preferable over the lowest cost plan for families that will take out the funds within a couple of years to pay for college. Blum recommends the higher-cost Illinois plan at .99 percent over his preferred Iowa plan at .65 percent in these cases. “For families that haven’t put away anything yet and will take the funds right out, the 3 percent state tax deduction is a bigger benefit,” he said.
The flexibility within the plan also makes a difference. “Some families don’t want to limit their annual contributions, but want to fund four years of school and grad school at once,” said Blum. “We look for plans with the widest range of choices.”
Blum noted a problem in keeping up with changes in the plans. He sends clients to the Web site www.savingforcollege.com for the most up-to-date information on plan features. “It takes an enormous amount of time to even keep up our own information on local plans,” he says. “Fortunately, there are resources on the Web that allow clients to compare costs and nuances.”
The 529 ultimately must fit in the overall financial plan for the client. The place in the overall plan often guides the advisor in making asset allocation choices. For instance, grandparents may be setting up the 529 for estate planning and thinking of a time horizon many generations hence. Parents are more likely to be establishing the account for their child, with a time horizon around the usual 18 years. “We do the asset allocation specific to the 529 account,” Blum explains. “The younger the child, the more aggressive we are. But we do consider what other resources the family has before making the final recommendations.”
Grandparents using the plans to get assets out of their estates might have different goals in mind. Stepp reported one client setting up a 529 for their yet-to-be born grandchildren. “Since the account holder can change the beneficiary, some wealthy clients might even choose to pay for their children’s or grandchildren’s education out of taxable wealth and let the 529 assets accumulate tax-deferred,” Stepp said.
Pulling together the details of the plans is a critical part of using the 529s. The states change features and the federal government’s policies also change. When established, the withdrawals from the 529s were taxable, and that changed with the recent federal tax cuts. The status of the tax-free withdrawals is in question after the sunset provision in 2010. “But we advise clients that even if the law reverses and withdrawals become taxable, it will be at the child’s tax rate, so these still make sense,” said Stepp.
Stepp also sees the states changing features as a trend moving in investors’ favor. “I see a time when these plans will be competed down to where all the best features of all the best plans will be offered in every state.”
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