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With all the media hype over 529 plans, it would seem the tax-advantaged college savings vehicles would be roaring across the radar screen of every education saver and advisor in the nation. One planner heralded the advent of 529s, the Darwinian offshoot of state prepaid tuition plans and named after the tax-code section that sanctioned them in 1996, as the greatest thing since sliced bread. The answer to why so few college savers are using them may be that the loaf hasn’t quite come out of the oven. What happens when it does remains to be seen.

Cerulli Associates, a Boston-based research and consulting firm–whose data can be found in our 529 directory beginning on page 57–noted in July that only 3.9% of U.S. families that include children under 18 have a 529 plan. But according to a Cerulli report published in November 2001 entitled “The State of The College Savings Market: 529 Plans in Perspective,” that figure (up from 2.4% in November) is expected to grow by more than 8% over the next five years. The average 529 account balance last year was less than $5,000 (37% of plans had less than $1,000), but that figure also is projected to rise, to just under $15,600 by 2006, according to Cerulli.

Advisors accustomed to utilizing sophisticated financial products on their clients’ behalf may find surprising a study conducted in May by Harris Interactive for AEGON Institutional Markets. (The latter company, a Louisville, Kentucky-based unit of AEGON Insurance Group, sells stable value products–insurance-based fixed income investments that maintain the value of the principal and accumulated interest–and believes stable value is a viable 529 plan component. In March, for example, Rhode Island added stable value to its investment mix.) AEGON’s study of parents with children under 18 years of age shows that bank savings accounts remain the most popular college savings vehicle. Sixty-one percent of parents use savings accounts, up 7% over 2001. Mutual funds and savings bonds are used by 44% and 37% of survey respondents respectively, according to the study.

Still, word about 529 savings plans is spreading fast: more than 40 financial services companies, many armed with mammoth marketing budgets, manage or distribute 529s. Cerulli notes in its 2001 report that as parents seek out information about new college savings vehicles, financial planners and advisors are discovering that they must “be prepared not only to offer advice about mutual funds, annuities and retirement, but also about college savings, which is quickly becoming a fourth and crucial component of every financial services providers’ product lineup.” Jeff Bogue of Bogue Asset Management in Wells, Maine, believes that many advisors are not up to speed on 529s because the plans are in constant flux. The state may at any time alter plan provisions or switch program managers, he explains. Matthew Olver, a planner with Spero-Smith Investment Advisors in Cleveland, believes that advisors, let alone the public, are still “getting comfortable” with 529s. “They’re a very different investment vehicle than anything else that has existed,” he says. “It’s not easy to fully understand exactly how they work.”

Heads Up

The Byzantine aspect of 529s is good news for plan-savvy advisors who stay ahead of the curve and for the growing legions of college savers who should depend upon them. The AEGON study indicates that the number of parents who have read or heard of 529 plans doubled between 2001 and 2002. Utilization of 529s has been slow for a number of reasons, not the least of which is that it’s hard for many Americans to save for college when pressured with myriad other financial concerns, especially retirement. As for 529s, they only came into vogue about four years ago (though the IRS added section 529 to the tax code in 1996). Before achieving tax-free status last year as part of EGTRRA, growth in the accounts was tax deferred, which necessitated saving money in order to cover taxes when taking money from the 529 plan–reason enough for many advisors not to recommend them. Also, each 529 state plan is composed differently, and none is particularly easy to understand. “All of the ‘noise’ on 529 plans makes them seem overly complicated for many parents, and they don’t have the time to research them on their own,” says Phil Dyer, senior manager at Wealth Management Services in Towson, Maryland. And as Bogue says, 529 plans are “kind of murky. You’ve got to figure out all the tax scenarios, the operational rules, funding minimums, and review at least 16 different investment choices–and choose a state.”

All 50 states, and the District of Columbia, are expected to have at least one 529 plan by the end of 2002. Data from Cerulli’s 2001 report on 529 plans show concentration of 529 assets to be in the 10 largest state plans: Ohio, New York (whose plan topped over $1 billion in assets as of year-end 2001), New Hampshire, Maine, Massachusetts, Rhode Island (the largest plan, with more than $2 billion in assets as of year-end 2001), Pennsylvania, California, Illinois, and Connecticut. Initial minimum and subsequent plan contributions vary from state to state (Nebraska is the only state with no minimum requirement), ranging from a low of $10 in Louisiana to a high of $1,000 in Massachusetts and New Hampshire. Some states impose higher initial minimums for out-of-state investors; Kansas and Arkansas require non-state residents to post $1,000 as an initial contribution, while in-state residents may open an account with $500 and $250, respectively. Cerulli notes that New Jersey requires subsequent contributions of $300 annually until the account reaches $1,200, at which point there are no minimums. Subsequent minimum contributions range from $15 in Colorado to $100 in New Mexico.

Aided significantly by the tax-free withdrawal status it received in 2001 (under prior law, 529 plan withdrawals were taxed at the child’s tax rate), 529 plans have become the nation’s preferred college savings vehicle, topping prepaid plans and Coverdell education savings accounts, formerly known as Education IRAs. Cerulli projects that assets in 529 savings plans nationwide will exceed $51 billion by 2006, growing at an annual rate of 48%.


As for the viability of the other savings vehicles, there isn’t much, at least according to John Stelman of Stelman & Associates in Lake Orion, Michigan, who for years has closely followed college funding. He finds the original Education IRA, with its $500 maximum yearly contribution, “a joke.” He considers the Coverdell version, with the contribution limit per beneficiary bumped up in 2002 to $2,000, thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, “a little less of a joke.” Louis Kokernak of Haven Financial Advisors in Austin, Texas, characterizes the Coverdell IRA as effectively being a nationwide “voucher” for parents who want to provide their children’s secondary or college education, adding that tax-free withdrawals for the Coverdell “extend to virtually all facets of the educational experience.”

The Coverdell does have its virtues, however. Suzzette Rutherford of Rutherford Asset Planning in Naples, Florida, likes it because of its secondary-education use, and because management of assets is fully under the control of the plan contributor. Like a 529, she adds, the monies in the Coverdell grow tax-free and qualified withdrawals for education are tax-free as well. She recommends the Coverdell to college savers who have only $3,000 or less to contribute each year.

Stelman believes that state prepaid plans, which provide a hedge against inflation (and which by last year had amassed total assets of about $14 billion, according to Cerulli) and a guarantee that savings will meet future education costs, offer too little flexibility, and will soon be extinct. “Since 1987, when the first prepaid came out in Michigan, 1,500 to 1,700 contracts a year have been going out,” he says, “which is a dismal failure.” Prepaids generally cover only state-funded public universities. How, Stelman questions, does a family and child who begin saving for college a decade before college freshman year, know with certainty that the child will still want to attend a state school when it’s time to apply? If the child decides instead to go to a private college or university, or not to continue his education at all, the parents will “lose a chunk of money,” says Stelman. He believes that sooner or later “somebody” will put a 529 savings plan together that offers, as a component, the prepaid-plan guarantee to pace inflation.

Hope or Hype?

Regarding college savings in general, KC Dempster, director of program development for College Money, a college counseling firm in Marlton, New Jersey, maintains that for the most part, “anything that helps to save money is good.” (See book review sidebar on page 54.) Parents today believe they must save $80,400 on average for one child’s college tuition, an increase of nearly $35,000 from what they held to be true in 2001, according to the AEGON study. Cerulli points out that families saving for a baby born in 2001 will need to accumulate nearly $250,000 to cover the total cost of sending their child to a four-year private college. Parents also are less optimistic about potential returns on their investments than they were last year, and are extremely risk averse, according to AEGON. Lynn Allen, AEGON’s director of public markets, says that “with the events of the past year and continued uncertainty about the stock market, parents are worried.” Their expectations regarding potential returns, while lower than in 2001, continue to be somewhat unrealistic; the AEGON study, conducted in March, found that on average, parents expect 19%, down from 24% in 2001. The survey found that only 10% reported an actual return of 10% or more–with significantly more parents reporting a return between 1% and 9%–compared to 18% in 2001. Boosting the parental apprehension level is the knowledge that the college tuition inflation rate, at around 7.5%, is double that of the overall inflation rate, according to College Money.

That said, are 529s the answer to parents’ college saving needs? A review of 529 attributes shows that these plans can be used for college expenses in any state (while prepaid tuition plans are designed for in-state use); and that parents (or whoever contributes) maintain control over the money in 529s, while custodial UGMAs (Uniform Gifts to Minors Act) release control of funds to students when they reach the age of majority–allowing them to jet off to Bali instead of Princeton. The allowable one-time gift of up to $50,000 into 529s provides enticing estate tax benefits (the gift can be taken back, though the donor must pay a 10% penalty to the federal government). This is especially advantageous for grandparents who wish to remove cash from their estates.

Other 529 benefits: the contributor can be virtually anybody; there are no limits placed on parent income; and adults can actually contribute to their own 529 plans if, for example, they wish to attend medical school. As noted above, withdrawals from 529 plans are tax-free (as long as the monies are used for education costs). And assets in 529s, unlike those in UGMAs, are not considered student assets in the formulas used to determine financial aid, though they were prior to the EGTRRA 2001 legislation. There’s a not-so-obvious catch regarding this benefit, which we’ll examine later.

“The 529 is a panacea,” says Stelman. “It meets all the criteria that anybody could have in terms of meeting needs in a college funding vehicle.” College Money’s Dempster notes that “To be able to save money for college and use it tax free for college is outstanding, because the compounding is phenomenal.” Dennis De Stefano of De Stefano Wealth Management in Maui, Hawaii, finds 529 plans to be “college savings, retirement planning, and a tax shelter rolled into one.” Doug Pauley, of Pauley Financial Services, Inc., in Pound Rock, Texas, says that “Section 529 plans are the perfect college-funding vehicles for grandparents,” though he isn’t a fan of 529s for parents unless they have fully funded their retirement and long-term care needs. “They have tremendous planning opportunities that are possibly broader than just saving for education,” says Jeffrey Mehler, an advisor in Centerbrook, Connecticut.

What’s Not to Like?

Even 529s’ staunchest supporters agree the plans are not for everyone. And some advisors are downright wary of 529s, feeling that the media-fueled enthusiasm they engender may make some college savers blind to the plans’ disadvantages.

Haven Financial’s Louis Kokernak is concerned that the plans are being oversold as an estate planning tool when inherently, he says, the disposition of assets from the plan is restricted for education use only. Jim Garvey of Northstar Financial Planning in Hudson, New Hampshire, doesn’t use 529s for estate planning at present, suspecting that the rules may be soon modified to eliminate the usefulness of the plan as an estate planning vehicle.

Many people are unaware that monies coming out of 529 plans are not eligible for either the tuition tax deduction (which starts in 2002) or the Hope Scholarship or Lifetime Learning credit, according to Jeff Feldman of Rochester Financial Services, Pittsford, New York. Apart from the possible 10% penalty mentioned earlier, there is a lack of control in terms of management fees that are charged for the plan, as well as in the selection of specific investments, since the contents of a 529 are dictated by the plan’s portfolio manager alone.

“If a manager has REITS in a fund portfolio, then you could select that plan and that portfolio for your 529 investment,” Garvey explains. “What you can’t do is independently select your own choices for the funds you want–you must find one with a mix that is to your liking.” In terms of investment options, most states have followed a similar path, according to Cerulli’s 2001 report. The states offer an age-based or years-to-enrollment-based portfolio as one option (the most commonly used), and one or more fixed or static allocation options, such as 100% equity or 100% fixed income. The report notes that 11 states offer investment options biased toward conservative investors, either as FDIC-insured, guaranteed, or prepaid-type investments. The average number of investment options in the existing 529 plans as of last November was four, and ranged from one to 11.

In 529s’ cautionary column there’s also the fact that these plans simply have no track record. This is especially troublesome to Michael Helffrich of PFP Advisors in Minneapolis, who says he looks for the hidden flaw in nearly anything–including 529s–searching for that elusive “bug in the works.” “Nobody knows what’s going to happen [with 529s],” he says. “Nobody’s looked at what happens when you start taking money out of these things; everybody’s talking about putting money into them, because that’s where all the sales people are making their commission.”

Ponder this, Helffrich says: The plans were created using a ’90s mindset, which included an assumption of low interest rates but not necessarily the possibility of higher interest rates. He reasons that since the U.S. is engaged in financing a war effort, interest rates will trend up, probably after the November elections. If there’s a war with Saddam Hussein, for example, interest rates could spike. A spike or upward trend could have an adverse effect on 529s, since most plans are mandated to invest in a combination of stocks, bonds, and cash. These portfolios start with a higher stock concentration when the future college student is youngest, and graduate to a higher concentration of bonds and cash when the student approaches age 15 or 16. Since high interest rates diminish the value of bond portfolios, the value of the 529 plan itself could be seriously diminished as well, Helffrich believes. “The real issue is, what is the average maturity in the bond fund and the average duration? How will that be affected by a spike of maybe a half-point or a point in interest rates? What will that do to that kid’s portfolio?”

Advisor Tim Hayes cites the matter of successor ownership as an overlooked issue in 529 plans. What happens, he says, if the contract owner dies? And what if the plan passes by way of the decedent’s will to someone who doesn’t feel obligated to use the assets for the beneficiary and instead withdraws the monies (and pays the penalties) and spends it?

Another potential pitfall, most artfully hidden, says Helffrich, is the 529′s impact on student aid. All 529 plan literature trumpets the fact that assets in 529s are not considered student assets in the federal formulas used to determine financial aid. “They [the literature] give you the truth but not the whole truth,” he says. What is not made clear, he says, is that payments made by the 529 plan custodian to a college or university one year will be counted as income to the student the following year. (Each student-asset dollar results in a loss of 50 cents in aid.) “All of a sudden it switches from the asset side of the parents to the income side of the child, thereby making the child ineligible for financial aid in most cases for the second year.”

One Size Doesn’t Fit All

It’s important to keep in mind, in the words of advisor Pauley, that while 529 plans are the current “darlings of the media, they really only make sense in certain situations.” While it’s difficult to come up with any rules of thumb dictating for whom 529 plans are best, this itself is another reason why advisors are sorely needed in ferreting out plan vagaries and making recommendations accordingly. At the end of the day, says planner Olver of Spero-Smith Investment Advisors, “there’s not really one type of person who it’s right for or not right for.”

Some generalities can be safely advanced, however. Most advisors find 529 plans well suited for older individuals, particularly grandparents who wish to save for their grandchildren’s college education while moving assets from their estate and maintaining control over their own largesse. A long-term saving horizon is also recommended. Helffrich finds the plans worth considering for college savers with young children, preferably newborns or under the age of five. “You need time for the tax-free earnings to build up,” he says. Along these lines, advisor John Stelman says he wouldn’t use the same plan for a three-month-old child as he would for a 17-year-old. “I’d move over to the PIMCO 529 plan for a 17-year-old because they’ve got the best bond funds in the U.S. But I wouldn’t use bond funds for a three-year-old, so I’d go over to a different plan–preferably one that uses a multi-manager platform.” Because of potential problems with financial aid, Helffrich recommends to clients seeking aid that they consider using 529s to fund half (every other year) of the student’s college education.

Income is another vital factor, over which there is marginal consensus. Some planners use as a loose rule of thumb in gauging a 529 plan worthiness, parental income in excess of $100,000–usually to avoid precluding financial aid (advisor Stelman hates using the word “income” because somebody earning six figures could still be getting a lot of financial aid, albeit not need-based). But as Dempster of College Money notes, there are myriad variables that come into play with financial aid formulas, and they are not all related to income. While 529s are good for anyone needing some type of forced savings on a monthly basis, they may not be the best for savers in very low tax brackets–savers who will derive scant advantage from the tax deferral and who won’t contribute significant sums on a regular basis. A person tossing into a 529 account $2,000 or $3,000 up front, followed by sporadic and meager contributions, may be charged $30 or $50 per year for account maintenance and a 1% annual fee, ultimately making the 529 cost ineffective.

Eeeny, Meeny, Miney…

Picking the best plan is a daunting task. The idea is to fund a plan with the combination of funds, and expenses, that you like, offers planner Jim Garvey. Generally this means finding a well-diversified and balanced plan, which is really a self-contained portfolio with a specific time span that is much shorter than the time horizon for retirement investing. “I like to use a fixed portfolio rather than an age-based portfolio so I can make the decision of where to invest on a periodic basis,” he says. Advisor Rutherford looks for, in order of importance: Good investment advisor offerings; availability of options as to investment allocations (not only age-based portfolios); low fees; and availability of state tax deduction.

For some, the latter consideration is often the first. According to Stelman, there’s generally some benefit to using a 529 from a client’s own state of residence, especially if the state offers a state income tax deduction for 529 plan contributions. College Money’s Dempster considers in-state benefits, then looks at the plan’s investment manager–not easy since no one has been managing 529s for more than a handful of years. Advisor Jeff Bogue’s first concern is a plan’s provisional aspects. “If I have a client who has a UGMA/UTMA account, I look for a plan that accepts these, because some do and some don’t.” He then examines fees and expenses, followed by the “investment scenario associated with the plan options.”

With the performance of 529 plans reflective of the current economic slump, “when you actually run the numbers you have to be confident that the plan itself can provide competitive returns to what you could get from the outside, managing it on your own,” says Olver. Major questions he asks when examining state plans include: What are the enrollment requirements? Who can be a beneficiary? What’s the minimum and maximum contribution? Is there a payroll deduction option? Then there are investment factors: Are static portfolios available? How diverse are the equity options? How are the different asset classes weighted within the portfolio? Does the plan have an age-based option or multiple age-based options? Naturally, he considers program expenses: What are the enrollment fees and annual maintenance fees? The expense of the underlying mutual funds?

Many state plans have 529 programs with loads, and some plans have funds that will pay a commission to advisors through a so-called advisor series fund. As College Money’s Dempster says, “If a client is looking to a financial advisor to help them make the decisions of which plan to use and then watching the plan and monitoring it, then the advisor really needs to be compensated for his time in some way.”

Fee-only advisors have a different set of obstacles to overcome. Olver, a fee-only planner, says being compensated for his work on 529s is something the planners in his firm have “struggled with internally.” They decided that for new clients, time spent on 529s would be included in the fee charged for the initial planning process. For current clients they may bill at a reduced rate for 529 assistance on an ongoing basis. Echoing the sentiment of many fee-only advisors, Olver says that “for the most part, it is not a money-maker for us. We see it as a value-added service, as something that–as a fee-only advisor–is the right thing to do.”

Many fee-only planners simply advise on 529s for free, though some are considering some sort of remuneration. Others, like Hayes, charge clients for their time. In Hayes’s state, New York, this works to the client’s advantage, as New York’s 529 plan is offered through TIAA-CREF, which doesn’t pay a broker’s commission. (A client could use another state plan, to avoid paying Hayes, but the client wouldn’t receive the New York income tax deduction, which usually would be greater than Hayes’s fee.) Bonnie Hughes of A&H Financial Planning and Education in Rome, Georgia, a member of the Garrett Planning Network, proposes to clients a two- to three-hour sit-down at $120 per hour. In this session she and the client will explore various college funding options, including a detailed review of the client’s home-state plan and a comparable 529 plan.

Into the Sunset?

While the economy and complexity of 529s has slowed their growth somewhat, the plans seem here to stay, their flexibility and options are likely to increase, and their use to proliferate. Expect the unexpected, however, says Helffrich, who calls these plans “a work in progress.” Early criticisms levied against 529s for being overly conservative–this at a time when age-based investing was the only option–are no longer valid, given the use of static allocation and the ability to change investment strategies yearly. Competition between state plans will also help ensure optimal returns and operational efficiency. Looming large over 529s is the fact that the federal tax-free treatment of plan withdrawals is subject to the sunset provision in the 2001 Tax Act. However, most advisors are confident that the sun won’t set on 529s, that the federal government will act prior to the end of 2010 to permanently retain the plans’ tax-free status–one of their biggest selling points. But as Dempster cautions, “a lot can happen between now and then.” Meanwhile, there’s much advisors can learn about 529 plans, if for no other reason than that their clients most likely will not. “You have to do some research,” says Stelman. “It’s not that my clients don’t have the intelligence to figure this out if they took the time, but they like the advice, and they don’t want to get involved.”