When President Bush signed the new tax bill on June 7, he fulfilled his campaign promise to give something back to the American taxpayer. But long after the rebate checks have been cashed, taxpayers still will benefit from the way the bill helps them save money for education, particularly the measures that will make the increasingly popular 529 college-tuition plans more attractive than ever. Most notably, as of 2002, the plans will be fully tax free for qualified withdrawals, rather than tax deferred as they are now.
In the days after the bill became law, financial experts and the media trumpeted the enhanced value of 529 plans. The Boston Globe, for example, reported, "The educational savings incentives included in the new legislation make a 529 college-savings program a virtual prerequisite for parents." Joseph Hurley, a New York accountant who has become one of the leading authorities of, and drumbeaters for, 529 plans, was even more succinct: "All I can say is, 'WOW!'"
It also became apparent that the beneficiaries of the new tax bill are not just the taxpayers, but also financial advisors, lawyers, accountants and estate planners who will help those taxpayers make sense of-and take advantage of-the bill's provisions. For financial advisors, when it comes to 529 plans, an easy sell just has become that much easier. That may have something to do with the fact that the National Association of State Treasurers estimates that 529-plan programs will grow from their current $9 billion in assets to $70 billion by 2011.
The Cost Of College
The rising cost of college tuition is one of the leading concerns facing Americans today-and it should be. According to the College Board, a not-for-profit educational organization, the average cost of college in 2000-2001, including tuition, room and board and books, ranges from $9,229 for a student who commutes to a public college to $24,946 for one who boards at a private college. Making matters worse, the cost of college is easily outpacing family income and inflation. That poses a problem in a country that stands among the world's worst when it comes to saving.
What's more, the traditional options that have tax benefits, particularly education IRAs, UTMAs, and UGMAs, have long been limited by a lack of control for the donor, the parents' income and the piddling sum of money that can be contributed. Putting away the education IRA maximum of $500 a year ($2,000 beginning in 2002) wouldn't make much of a dent in today's tuition costs, no matter how early one starts. And while it's true that the amount of financial aid available has never been higher, the competition for it has never been more intense.
The Coming Of 529
In 1997, the federal government addressed this issue with the Taxpayer Relief Act, officially titled Internal Revenue Code Section 529: Qualified State Tuition Programs (such programs had existed in various forms at the state level since 1986). There were two components: a prepaid plan, which guaranteed that an investment would keep up with the cost of inflation, and a savings plan, similar to a mutual fund and which offered a variable rate of return that could outstrip inflation or fall below it. The latter offered a range of investment options, from aggressive growth to fixed- income funds, and unlike prepaid plans, investors could contribute whenever they wanted, not just at designated times. Each state was given control over its 529 plan and allowed to bring in an outside money manager to offer a range of state-approved mutual funds.
The benefits of the savings plan were dramatic. First, 529s did not discriminate against the rich-anyone in any tax bracket could contribute to a plan in any state, whether they lived there or not. Equally important, a donor could make a much larger contribution than under an education IRA, up to $50,000 a year (by front loading five years of a $10,000-a-year tax-free gift) in some plans and as much as $250,000 over the life of the plan. There was more control than there was with UGMAs or UTMAs because the beneficiaries did not get the money until they actually had to pay their tuition as opposed to getting it when they turned 18 (or, in some states, 21). Furthermore, the 529 money was not considered to be part of the donor's estate, and when it was withdrawn, the income was taxed at the beneficiary's rate, not the donor's.
Those benefits have ensured the popularity of 529 college-tuition plans. Every state now either has a qualified tuition plan or is introducing one. And the states have attracted some of the best-known names in the world of finance to manage their plans, including Merrill Lynch, Fidelity, Vanguard, Citigroup, Mercury and TIAA-CREF. It's not surprising that, according to Hurley, 529 savings plans took in $2.5 billion in assets through 2000. And that was before the new tax bill came along.
The Tax Bill And 529 Plans
A number of provisions in the new tax bill are impacting 529 plans. But here are the two headliners: Starting next year, qualified plan withdrawals will be free of federal taxes (and in most cases, free of state taxes as well), and investors will be able to roll over accounts into other 529 plans once a year without changing the beneficiary and without incurring penalties. The change from a tax-deferred plan to a tax-free one is obviously an enormous selling point for investors and advisors. And the ability to move from one account to another, though it requires an investor to change plan sponsors, addresses one of the main arguments against 529 plans: their relative inflexibility. Now if they are concerned about the state of the market, investors can move, for example, from an equity-based investment strategy to a fixed-income one. As it stands, money can't be moved within a plan without changing beneficiaries, but any additional contributions to that state's plan could be put into a more conservative or aggressive fund at the client's discretion. Some 529 plans already offer age-based investment options that shift money into less risky funds as the beneficiary nears college age.
There is one other side benefit for investors: The odds are good that now that 529s are even more attractive and the battle for investors will become more intense, the firms offering them may have to become more competitive by increasing the range of investment options and lowering commissions and fees.
The Opportunity Of 529
For financial advisors, 529 college-savings plans have all the right touch points-children, education, saving and tax breaks. That explains the rapid growth in the amount of money contributed to such plans. But there still are many investors who have yet to make the move to 529 plans, despite their suitability. In fact, according to a recent article in The Wall Street Journal, the two most common ways of saving for college tuition today are bank accounts and savings bonds.
A recent survey commissioned by Merrill Lynch and conducted by Prince & Associates was revealing about why investors have been slow to put more money into such programs: indecision and a lack of professional guidance. Prince & Associates talked to more than 1,000 parents with annual household incomes of at least $75,000. Most understood that college tuition costs were rising and realized how important it was to their children's well- being. But even so, they weren't doing much about it. More than half hadn't started to save, and only a handful of those who had were doing so systematically. Our study also showed that two-thirds of those parents wanted to work with a financial advisor and only about one in seven had done so. This explains the appeal of 529-and the potential for financial advisors.
A Complicated Investment Option
One reason investors have not opened 529 plans in greater numbers-and one of the best opportunities for informed financial advisors to connect with clients and prospects-is their complexity. They are not nearly as simple to understand as mutual funds or even Roth IRAs. In fact, each state has selected its own investment manager, and each state's plan may have a different range of options, fees, holding periods and contribution limits. It's up to the advisor to shorten the menu and match the right plan with their clients' needs. (Two excellent sources for comparative information are Hurley's Web site, www.savingforcollege.com, and the College Savings Plan Network, which is run by the National Association of State Treasurers, at www.collegesavings.org.)
For advisors, now is the right time to talk to clients and prospects about 529 plans because of two pivot points: the improvements that the tax bill will bring about and the state of the economy. As noted, a number of funds, 529s and others, have taken a beating over the past year. But two familiar lessons are to be learned and conveyed to investors: patience and diversification. For those whose children are far from college age, there's still plenty of time for the funds to recoup. Many of the 529-plan funds to take the biggest beating were aggressive-growth funds that rose and fell with the Nasdaq. More conservative options with funds that spread the investment across asset classes are less likely to be volatile. Again, it is up to the advisor to explain to clients the best long-range options in keeping with each client's objectives and risk threshold.
The new tax bill and the economy have created an opening for advisors to discuss 529 plans with investors who have children or grandchildren and even those without children, which covers just about every client and prospect. Advisors who want to share in the growth of these plans would do well to act now, before one of their competitors does; 529 plans have become an option too good to be overlooked.
Hannah Shaw Grove is managing director and chief marketing officer of Merrill Lynch Investment Managers. Russ Alan Prince is president of the consulting firm Prince & Associates.