Weigh tax benefits versus uncertain future, ongoing regulatory confusion.
Since their introduction a few years ago, Section
529 savings plans have proven to be a popular way to help meet the
king's ransom required to fund a college education. But recent
investigations by industry and government regulators, however, have
raised concerns about their future.
The NASD is looking into 20 unnamed brokerage firms to determine whether financial advisors steered too many clients toward high-cost 529 plans outside their home states, without explaining the tax advantages of in-state plans. Meanwhile, a Securities and Exchange Commission task force is probing 529 plan fee structures and investor disclosures. And in May, the Municipal Securities Rulemaking Board published for comment additional interpretive guidance on the disclosure, suitability and other customer protection obligations of municipal securities dealers who market 529 plans.
Financial advisors who specialize in college planning say that while the recent investigations haven't changed their own views on 529s, the negative publicity has made some clients wary. "There is a heightened awareness of 529 fees and the fact that in many cases, those fees offset the tax benefits the plans offer," says Rick Darvis, principal of College Funding Inc. and a tax professional in Plentywood, Mont.
Others say that the high costs and poor investment performance of some offerings have deterred those who have already invested in them from jumping in again. "Many people who were steered into high-cost 529 plans haven't had a good experience, and they're just not that interested," says Gary Carpenter of College Planning Services in Syracuse, N.Y. "Frankly, when I talk to parents who are saving for college, 529 plans do not rank high on the list of options."
Despite such reservations, it's hard to deny their tax advantages. Although contributions are not eligible for a federal tax deduction, investment earnings in the plan grow tax-free and withdrawals used to pay for a beneficiary's qualified educational expenses are exempt from federal taxes (although, in some states, they are subject to state taxes). Individual states may offer other incentives, such as an up-front deduction for contributions. There are no income limits on participation, contribution limits often exceed $200,000 per beneficiary, and the donor, most often a parent or grandparent, maintains control of the account.
The draw of those tax benefits has helped keep 529 plans in the forefront of college savings options. Investors poured $13.65 billion into 529s in 2004, up from $11.43 billion in 2003, according to Financial Research Corp. Assets in 529 plans reached an estimated $55.4 billion at the end of this year's first quarter. Estimated net new contributions in the first quarter were $3.9 billion, compared with $4.6 billion in 2004's fourth quarter and $4.1 billion in 2004's first quarter, according to FRC.
That loyalty may be tested over the next few years as the tax-free treatment of distributions used for qualified higher education expenses is scheduled to expire on December 31, 2010. Unless Congress makes changes, anyone with a child who does not finish college by then may not be able to make tax-free withdrawals when needed. However, Congress is moving to make the tax-free treatment permanent. Bills were introduced in May in both the U.S. House of Representatives and Senate to eliminate the 2010 sunset of the tax exclusion.
Another issue is the widely disparate state tax treatment of contributions and withdrawals that has left many 529 investors baffled. Twenty-five states and the District of Columbia offer a tax deduction or credit for contributions, but no state offers the same benefit for residents who buy out-of-state plans. Withdrawals for qualified educational expenses are tax-free in some states, even for out-of-state plans, while others tax withdrawals of distributed earnings. Switching to another plan can be costly because some states require a "recapture" of prior deductions when participants switch to out-of-state plans.
Darvis cites other glitches. While the plans may be assessed at a low rate under federal financial aid guidelines, institutional aid awarded by schools may not treat them as favorably. In some cases, he says, "they can reduce school aid on a dollar-for-dollar basis." Parents who fail to coordinate withdrawals with various educational tax incentives face a potentially hefty tax liability. Donors can't fund an account with securities they already own, and transfer tax liability to a child through gifting, because contributions must be made with cash.
Plan advocates acknowledge hurdles, but remain supportive. Joseph Hurley, author of The Best Way To Save For College: A Complete Guide To 529 Plans, notes in his book that 529s "offer powerful and unique tax advantages not available with other college savings options." In many cases, he says, a plan with reasonable expenses beats saving in a taxable account, even one stocked with low-cost, tax-efficient index funds. The tax advantages of the 529 are particularly powerful when part of the portfolio is in fixed-income investments, since interest is taxed at higher rates than capital gains in a taxable account. And they're an even better deal in states that allow a deduction for contributions.
As for the sunset provisions that threaten the tax-free status of qualified withdrawals, Hurley points out that even if Congress does not renew the favorable treatment, the earnings portion would be taxed to the student beneficiary, not the parent. "While there are no guarantees, it is difficult to believe that Congress will fail to preserve the 529 exclusion considering that millions of families will have a direct interest in these programs by the time 2011 rolls around," he maintains.
Bill Raynor, director of education savings at AIM Investments, says that even with uncertainty about future tax treatment the plans are still seeing strong growth. "I'm optimistic about prospects for making the tax-free treatment of withdrawals permanent," he says. "Once that uncertainty is lifted, there should be a marked increase in participation. What we're seeing now is just the tip of the iceberg, because only a small percentage of families with children under 18 even know what a 529 plan is."
Keeping Options Open
As the industry works the kinks out of some nettlesome issues, financial advisors might weigh 529s against other college savings options, such as IRAs, Coverdell Education Savings Accounts and custodial accounts.
Coverdell Education Savings Accounts, a popular choice among younger families moving gradually into a college savings plan, allow an individual to make contributions of up to $2,000 a year per beneficiary to a trust or custodial account established on behalf of any child under age 18. The contributions are not deductible but the amounts deposited accumulate free of tax. Withdrawals may be tax-free to the beneficiary if they are used to cover qualified education expenses. The accounts also can be used to pay for secondary school expenses, which 529 plans cannot.
Carpenter says that while he sometimes recommends Coverdells, the annual $2,000 contribution limits their value. He often advises parents looking to save larger amounts to keep things simple by setting up a taxable account in their own names and funding it with tax-efficient investments, such as index funds or stocks they intend to hold over the long term. "The approach offers maximum flexibility," he says. "You can use whatever investments you want, invest as much as you like, and deduct capital losses. And if the kids decide not to go to school or you don't use up all the money, the excess can go toward retirement." When the child reaches college age the parent can gift securities to their offspring, who will typically be in a lower tax bracket and pay a lower rate than the parent on any long-term capital gains.
Carpenter also suggests setting up a Roth IRA for a child who has earned income. This year, an individual under age 50 can make nondeductible contributions of up to $4,000 or 100% of earned income, whichever is less, and the contribution limit increases to $5,000 in 2008.
Distributions are penalty-free if used to pay for qualified education expenses, and any withdrawal of earnings will be taxed at the child's rate. Withdrawals can have an impact on financial aid, so the strategy works best for parents who do not expect to receive such assistance, he says.
Parents can also set up a Roth IRA (subject to income limitations) in their own names and make penalty-free withdrawals for college expenses. For anyone over age 49, the contribution limit is $4,500 this year, $5,000 in 2006 and 2007, and $6,000 in 2008. Because Roth IRA distributions are first considered a return of principal, someone could withdraw up to the amount of their contributions for college expenses, and leave the earnings untouched in the account until they are able to make tax-free withdrawals at age 591/2.
Cash-value life insurance that allows a tax-deferred build up of value and a tax-free death benefit is an often overlooked college savings option, says Darvis. "The premium payments act as a kind of forced savings," he says. "The policy is not assessed in financial aid calculations. And if the policy holder dies, the death benefit ensures that children will still be able to attend college."
One common strategy that will probably see less use in the future is leaving money saved in various education accounts untouched so it can continue to grow, and using low-interest student loans to pay for college. While the tactic made sense when student loan rates were scraping bottom, it will soon lose much of its allure with a scheduled rise in rates on Stafford loans and other forms of federal aid. Given those higher rates, many parents will have to dig even more deeply into home equity and savings to meet tuition bills that continue to defy gravity.