Tax free still trumps taxable accounts just about every time.

Have 529 plans-the not-so-long-ago media darlings of education savings-lost their shine?

First, the plans were stung by the same angry stock market that wounded nearly all U.S. equity investments over the past three years. Then President Bush signed a $350 billion tax bill into law, putting taxable accounts into seeming contention for the education dollars that had been flowing into 529 plans.

Created in 1996, 529 plans only began to take off in 2001 when Congress significantly increased their tax benefits. By the end of last year, 3.1 million accounts with more than $20 billion in assets were open, according to Boston-based Cerulli Associates. That's up from $3.1 billion in 556,000 accounts just two years earlier. With college costs expected to soar in 18 years to more than $100,000 for public college tuition and more than $250,000 for private college, parents need all the help they can get socking away even part of the tuition tab they're expecting to foot.

But now, with the new tax act reducing capital gains and dividend rates to almost nonexistent levels for folks with little or no income (children and grandchildren often fall into this tax bracket), taxable accounts put in kids' names can be used as potentially tax-efficient vehicles for college savings. We say potentially because there are a number of caveats to that tax-efficiency, which we'll discuss. The point is that 529 plans must be used for education purposes to qualify for tax- and penalty-free distributions, while taxable accounts may used however an investor sees fit, should a change of plan or an emergency arise.

The flexibility and less onerous taxes seem to be attracting planners and investors to taxable education savings accounts. "As an advisor, I am not recommending 529 plans until I see clients put enough assets into taxable accounts," says Patrick Horan, managing partner of Horan & Associates Financial Advisors Ltd. in Towson, Md. "I think 529 plans are great, but what if your plans don't work out? What if you lose your job, or the kids don't want to go to school or get scholarships and don't need the money? It's just silly to have the tax tail wag the dog."

Investors need to weigh the "tax risks" of these plans, Horan says, especially now that even the top rates for capital gains and dividends have been reduced to 15%. To him, the major risk with 529 plans is the possibility of having to pull money out early and use it for something other than education. Investors who do that pay income tax and a 10% penalty on earnings.

"Time and time again I see people come in who were using tax strategies that now, because of a layoff or some other situation, weren't the right ones for them," says Horan. A handful of his clients have drawn down 401(k) plan assets after losing their jobs. The tax treatment of early withdrawals from 401(k)s and 529 plans is identical, although many 401(k) participants can borrow their money to avoid the taxes and penalties. The planner says he likes clients to accumulate as much as $500,000 in taxable accounts before he'll recommend a 529 plan.

But not all planners or college savings experts agree with Horan. In fact, many still believe that the overall benefits of 529 plans trump taxable accounts on many fronts. "I think investors always have to evaluate all of their options, but I think that while there are competing options for savings, 529 plans still shine," says Joseph Hurley, founder and CEO of, in Pittsford, N.Y., a nationally known information source for investors and planners. Hurley routinely evaluates all the bells and whistles on competing plans, but he still believes that the tax-deferred growth in 529s, their tax-free distributions and the continuing control parents get over the accounts make them the best choice for most households.

While taxable accounts, with their new low tax rates, can sound like a great education savings opportunity, the case for them often ignores some extremely pertinent and potentially costly facts.

This is especially true when it comes to rebalancing or changing investment options in a taxable college savings plan. With a taxable account, the investor will get hit with income tax or capital gain rates depending on when they sell, all the while paying taxes on whatever dividends are paid. True, the capital gains and dividend rates are 5% for the lowest income brackets into which, presumably, pre-college age kids will fall. Still, even with lower rates, the taxes on even a fairly actively managed taxable account can take quite a toll over a ten- or 15-year investment period, says Carol Zoubek, director of investments at New England Financial Planning Group in Burlington, Mass.

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