From the April 2004 issue of Investment Advisor • Subscribe!

April 1, 2004

Buy Now, Save Later

Time may be running out for 529 plans. Should clients get in while the getting's good?

The mounting assets in 529 college savings plans are a telltale sign of their popularity: From $19.2 billion in assets at the beginning of 2003, 529 plans now hold a healthy $35.2 billion in assets. Parents and grandparents alike have grown partial to 529s because they can help them serve two goals: set aside money for their children's and grandchildren's college education, and remove taxable money from their estates.

But what does the future hold for 529s? The possible elimination of the estate tax in 2010 could render 529s extinct. Passage of the Bush Administration's Lifetime Savings Accounts (LSAs) would have a devastating effect on 529s. The IRS is proposing changes to 529s that would restrict their use and make them less attractive. And the Securities & Exchange Commission (SEC), at the behest of Congress, recently created a task force to study the transparency of 529s, SEC oversight of the plans, and whether 529 plans' high costs and fees mitigate the tax advantages intended by Congress.

One could argue there are a lot of variables working against 529s. That's why Karen Cunningham, a partner with Oklahoma Financial Center in Oklahoma City, is telling her clients to get in while the getting's good--to take advantage of 529s while they can. Because 529s are part of the estate tax legislation, they would be eliminated in 2010 when the law sunsets. "If Congress doesn't extend the law in 2011, 529 plans could go away," Cunningham says. She's urging her clients to take advantage of 529s now, and fund the plans as much as they can, "because who knows what's going to happen in 2011."

The IRS wants to modify 529s' structure so the plans aren't used as tax shelters. Under the current law, 529s are "wonderful estate planning tools," she says, because they allow the account owner to reduce his or her estate while continuing to control the assets. "You don't see this with a lot of other estate-planning tools," Cunningham says.

Suppose Grandma and Grandpa wanted to put $110,000 (each is allowed to gift $55,000 at one time) into a 529 plan for a grandchild's education. Grandpa is happy because he can be the account owner and control the money while reducing his estate, and he can provide a nice chunk of dough for his grandchild's education. As it stands now, the law allows the grandchild to use the money for education purposes, or let it grow in the 529 plan indefinitely and pass it on to other siblings. But under the new IRS proposal, the grandchild could only let the money grow until age 35. "If the money has not been taken out by the time the beneficiary (grandchild) reaches 35, she would be forced to take out the money and pay taxes on it," Cunningham says.

The IRS is also proposing that the beneficiaries gain control of the accounts when they reach age 18. "The ability for the grandfather to have control of the account for a long time would be jeopardized," Cunningham says. The $110,000 that was gifted to the grandchild at, say, age three, could grow to as much as $300,000 to $400,000 by age 18, she says. "Who wants to give an 18-year-old $300,000 to $400,000?" The grandfather's ability to get the money out of his estate, to maintain control of the money, and to see it grow would be wiped out. And he would no longer have the security of knowing that when he dies, his wife could take over the account.

The IRS has said that existing 529 plans will be grandfathered, so any changes that are adopted won't affect those plans. "We're really pushing everyone to open [a 529 plan] or consider it just to get the grandfather [clause]," Cunningham says. "We have a wonderful tool here [in the 529 plan], and it's a shame that the IRS is starting to mess with it." The IRS is still accepting comments on its proposals, so it's hard to say when any changes may be adopted.

No Lifetime Guarantees

And what about LSAs? Do they sound the death knell for 529s? Joe Hurley, a CPA and director of SavingforCollege.com, thinks LSAs are so "attractive" that money would naturally flow to them instead of to 529 plans. But 529s could stay alive if LSAs saw the light of day, Hurley says, because 529s have much higher contribution limits. LSAs have a $5,000 cap. "Even after a wealthier individual maximizes his LSA contribution, he might still want to put additional contributions toward a 529," he says. Another thing that works in 529 plans' favor is that "some states can add state tax deductions for 529 contributions," Hurley says. "You're not going to have that with the LSAs or Coverdell ESAs."

Hurley notes that it's important for advisors to consider estate tax benefits when determining a client's suitability for a 529 plan. For instance, it might be better for a client to use his home state's 529 to get the state tax deduction, as opposed to using an out-of-state plan that doesn't offer a tax deduction.

Planner Cunningham says LSAs could cause problems for 529s because they're more flexible. And the $5,000 that's put into an LSA can be taken out for any reason tax free, she says. "Why would you want to put your money into a 529 that's restricted to education?" The LSA's $5,000 maximum contribution is the most the average American can afford to put into their child's 529 on an annual basis, she says. "States have put a lot of money into administering these 529 plans," Cunningham says. Passage of LSAs would hamper states' ability to continue to administer their 529 plans because money would flow to LSAs, not 529s.

Gina Koprowski, director of financial planning at Delessert Financial Services, Inc., in Waltham, Massachusetts, says LSAs would also be attractive because they offer the owner the same type of account control as 529s. A client "can open an LSA in their name and have it earmarked for the child," she says. But, unlike the 529, the LSA doesn't have to be used for education. "If Junior decides not to go to school, he has money for something else." Other drawbacks associated with 529 plans, Koprowski says, are the costs associated with the mutual funds. The client is "also paying for management [of the account], and is subject to the constraints of the fund company providing the funds."

Hurley says that many mutual fund providers are attempting to make their products more attractive to advisors "by expanding the menus of investing options [within 529s], including a lot of single-fund options." Traditional 529 plans have offered multiple-fund options, he says, "but now advisors feel more comfortable with a single mutual fund within a 529 plan." The pricing of funds within 529s has drifted more toward conventional mutual fund pricing, Hurley says. "There seems to be a trend of waiving the A-share load on money coming over from a different 529 plan." Moreover, you'll usually find more underlying investing options in advisor-sold 529 products than in direct-sold 529 plans, he says.

Yet another issue that could hamstring 529 plans' growth is the SEC's recent decision to investigate what Michael Oxley, chairman of the House Financial Services Committee, thinks are trouble spots within 529 plans. Specifically, Oxley is concerned that 529 investors don't receive adequate disclosures about how the funds within 529 plans are being invested. Another concern, Oxley told SEC Chairman William Donaldson in a February 4 letter, is that the high costs and fees associated with 529 plans are offsetting the plans' tax advantages.

Hurley says that the "SEC can certainly make some noise about what they see happening with 529 plans, but the regulator has limited authority under the law" to enforce any changes. The SEC's only authority when it comes to 529 plans is with respect to the anti-fraud provisions of the federal securities laws. And because 529 plans are exempt from SEC registration, Hurley says, the plans "are not subject to the level of scrutiny that registered securities like mutual funds are."

The Municipal Securities Rulemaking Board (MSRB) governs 529 plans, and each state is responsible for regulating its securities. But Hurley says that if the SEC "views the states as not providing adequate investor protection, then I'm sure they'll do everything that's within their power to enforce some changes."

And what about 529 plans' high costs and fees? "There's no question that most 529 plans charge additional fees and expenses over direct investments in mutual funds," Hurley says. "However, the tax benefits typically far outweigh any expenses of the program." But the level of expenses does affect an investor's return, he says, "and therefore is an important consideration in evaluating the decision to invest with a 529 plan as well as the decision of which 529 plan to use."

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@ia-mag.com.

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