NU Online News Service, Aug. 16, 12:16 p.m. – Waddell & Associates Inc., Memphis, a fee-only investment advisory firm, says clients should think carefully before setting up 529 college savings accounts.

The 529 programs, based on Section 529 of the Internal Revenue Code, offer generous federal and state tax credits and tax deductions on contributions and account earnings.

Some states let residents use 529 account assets to cover their own tuition and education expenses as well as the expenses of children and grandchildren. In theory, a resident in one of those states could use a 529 account to cover the tuition payments, living expenses and other costs involved with “retiring” by becoming a full-time student.

But Waddell has published an analysis by Phyllis Scruggs and Carol Lee Royer, two financial planners at Waddell, recommending that investors consider factors other than tax savings when looking at the accounts.

Many states have hired a single investment company to manage the mutual funds for their 529 programs.

Even if the funds within the fund family have different investment objectives, they may own shares in the same companies or have other characteristics that reduce diversification, Scruggs warns.

Some 529 programs come with pre-set investment allocations that become more conservative as the likely student-beneficiary nears college age. Aggressive investors may be happier investing on their own, Scruggs says.

Royer recommends that investors make sure their finances are in order before locking assets away in 529 plans.

Investors who withdraw 529 funds for purposes other than paying qualified education expenses must pay income taxes on the funds and a 10% penalty.

To avoid paying the extra taxes and penalties, an investor should consider paying off credit card debt and setting up a substantial emergency cash fund before contributing to a 529 plan, Royer says.

The federal government also offers an Education Individual Retirement Account program.

The contribution limits for EIRAs are lower than for 529 programs, but withdrawals for qualified education expenses are tax-free, and the investment options are far more flexible than those available through the 529 programs, Royer says.