It may have been the biggest news in college savings in years.

In mid-January, the White House released a list of proposed tax changes that included removing the tax-exempt status of withdrawals from future contributions to 529 college savings accounts. (Current accounts would not be affected.) Then, before the month’s end, the president did an about-face and dropped the plan.

“He received a lot of negative comments to the proposal,” surmised Joe Hurley, founder of Pittsford, N.Y.-based SavingForCollege.com.
Indeed, congressional representatives from both parties had objected, leading to what a White House official termed “a distraction” from more important matters. Still, the short-term uproar illustrates how highly 529 savings are prized in a world of ever-rising college costs. And it’s just the latest example of a growing trend.

A Double-Edged Sword
Barely a month earlier, in December 2014, the president signed the Achieving a Better Life Experience (or ABLE) Act, which was seen as a boon for college savings. The law lets people with disabilities save up to $100,000 in tax-deferred accounts without jeopardizing their eligibility for government assistance, as long as withdrawals are used for qualified expenses such as wheelchairs or doctor bills. Tucked into the bill was a provision that permits college savers to change their 529 accounts twice a year, instead of once, allowing 529-holders to rebalance their portfolios more frequently as market conditions change.

“This provision is important for families who are investing in education through 529 plans and want to have more flexibility and control over their accounts,” explains Betty Lochner, chair of the College Savings Plans Network, an industry group based in Olympia, Wash.

But not all observers agree this is good news. “It is a welcome change but will have minimal impact on the industry,” Hurley says. “Most of the industry was hoping for four changes in a year. It is still a long way from self-directed accounts, which would have huge impact.”

Others fear it could reduce returns. “This could affect the 529 industry in a negative way, allowing the individual investor to try to time the market,” says Connor B. Holly, an advisor at Sage Rutty & Co., in Rochester, N.Y. Holly points out that more than two-thirds of the nation’s 92 plans are sold directly to consumers, not through brokers, “meaning the parents are choosing the investments,” he says. “These accounts are best taken with a long-term investment mind set.”

Even those who might favor greater flexibility express some concern. “This is a double-edged sword,” says Thomas J. Henske, a partner at New York-based Lenox Advisors. Clients “should have the right to change more than one time per year, [but] it is generally not advisable.”

A Rising Tide…
The 529 is a state-run savings and investment plan that grows tax-free. The withdrawals from them have been tax-free as well, as long as they are used for college or graduate-level education (nonqualified withdrawals incur income taxes plus a 10% penalty). The investment choices in these plans are based on a student’s age—they automatically shift assets from equities to bonds as the beneficiary nears college age. (Experts say these accounts should nevertheless be monitored to make sure they are on track.)

Even before the ABLE Act passed, 529s appeared to be holding their own in a recovering market. As of September 30, 2014, the most recent date available, the aggregate value of all 529 assets had jumped 13.5% from a year earlier, to $217.2 billion, as measured by data monitor Strategic Insight. “The overall increase in 529 plans nationwide means that, post-recession, people see the value of a higher education and the need to save for college costs,” says Lochner.

In fairness, however, those gains can’t entirely be attributed to inflows of new money. They owe something to overall market growth. After all, over the same 12-month period the S&P 500 advanced 16.4%. “When you adjust for market performance, the industry is just creeping forward, not leaping forward,” says Hurley. “I’m hoping for more.”

If the bull market continues, he may get his wish. “As people continue to make more money, they will continue to fund these plans,” says Henske. “If we have a repeat in the markets from 2008, you would most likely see these contribution levels decrease.”

Broker-Sold Vs. Direct-Sold
By far, the largest share of 529 assets is currently found in Virginia’s CollegeAmerica plan, which as of September held $46.8 billion. (In comparison, the next best-funded 529 was New York’s College Savings Program-Direct, at just $15.8 billion.) Made up of American Funds portfolios managed by the Capital Group Cos., CollegeAmerica is sold only through advisors. “This means there is a national sales force promoting college savings through the Virginia plan,” notes Lochner.

Advisor-sold funds tend to be more expensive than those sold directly to the public, but the advantages can outweigh the costs. By working with an advisor, clients are better able to sort through different options and limitations. Advisors can also fit college savings into a broader long-term financial plan. And they may have access to certain load funds that direct-sold 529s do not, such as those managed by American Funds.

“The growth of this particular plan shows that more people are working with financial professionals in helping them address their concerns, the future cost of college evidently being one of them,” says Holly.

Lower Fees And More Choices
At the same time, basic 529 fees have come down dramatically. In the past, their expense ratios were significantly higher than those of their underlying mutual funds. “This represents the most significant trend in 529s,” insists Hurley. “Program expenses can no longer be used as an excuse to stay away.”

The least expensive direct-to-consumer 529 is Louisiana’s fixed-income fund, managed by the state treasurer and subsidized by the state. The cost can be as low as zero, but only state residents may participate. The most expensive 529, in Washington, D.C., is also for local residents only, though outsiders can buy in through a broker for an additional fee.

If lower fees are big news, so is the variety of options in 529s. They are now available in 49 states plus D.C. (Wyoming is the sole exception), and most, though not all, are open to investors from anywhere in the country. “Each state has its own specific direct-plan sponsor where the investment selections have grown substantially,” says Holly, citing a study that shows the number of direct-sold accounts nationwide jumped from 510 to 722 in the past four years alone.

Most direct-sold plans have “gravitated toward index funds,” remarks Hurley, which of course are passively managed and therefore among the least expensive. Advisor-sold plans represent a broader assortment, he adds.

The Pros And Cons Of Prepaid Plans
Another recent trend concerns 529 prepaid tuition plans. Unlike other 529s, they require clients to choose an in-state public college in advance (though some can be converted for private or out-of-state colleges later). They allow clients to lock in current tuition costs, hedging against inflation risk. “There are currently 13 prepaid tuition plans offered in 12 states,” says Lochner. “Depending upon the specific plan, tuition semesters, years or units may be purchased through a onetime lump sum purchase or monthly installment payments.”

Recently, however, a growing number of them have closed. “Colorado, Kentucky, West Virginia and South Carolina have chosen to close theirs,” says Holly. “During recessions, state support for higher education funding is typically the first on the chopping block.”

These failures could, in turn, alter actuarial assumptions and put additional pressures on the remaining prepaid plans, he cautions.

Funding And Taxation
Experts say it’s never too early to open a 529. Clients can even start one in their own name before having children and simply change the beneficiary later. Contributions also make great gift ideas for baby showers. Note that when it comes to gifting, 529 contributions qualify for the annual $14,000 gift tax exclusion. If you give between $14,000 and $70,000, you can use five-year cost averaging—reporting it as a deposit made over a five-year period—to shelter the extra amount.

All contributions have to be cash-based. “You cannot contribute stocks or other types of non-cash property,” says Hurley. But clients can do electronic transfers from cash accounts or even direct deposits from a paycheck.

Grandparents can open a 529 account in their own name or contribute to an existing one. It’s important to realize, though, that withdrawals from a grandparent-owned 529 will be considered extra student income—unlike one owned by the parent or the student—which weighs more heavily against financial aid considerations than parental income. When financial aid officials try to gauge a family’s expected contribution to tuition, they assume parents can contribute up to 5.64% of their assets, whereas the students themselves are expected to put in as much as 20% of their own assets.

Still, gifting to a 529 can be an important part of a financial plan. “The benefits of potentially using 529s for gifting to children and even grandchildren” is often overlooked, says Henske.

Indeed, 529 contributions can be used for multiple generations and as a part of legacy planning. That, in part, is because beneficiaries can be changed without penalty. That is, if one grandchild decides not to go to college, the funds can be used for another grandchild who does.
Or they can be held till the grandchild changes his or her mind. There are no distribution requirements or time limits. “An account funded now can help pay for family descendants a hundred-plus years from now, without income taxes,” says Hurley.

Contributions to a 529 are not federally tax-deductible, but 34 states—New York, for example—and D.C. do offer tax deductions or tax credit “for contributions to that state’s 529 plan” (and in a few cases, to any plan), says Lochner. Be warned, however: Participating in another state’s 529 may make you ineligible for your home state’s deduction.

It’s important to know your state’s rules. While many require 529 funds remain invested for at least one year, others don’t—creating an interesting loophole. “This allows an individual to make a contribution to a 529 plan, claim the deduction and withdraw the funds the next day to pay for tuition,” says Holly.