• Financial Planning
  • 529 Plans: Educate Yourself Before You Invest

    by John Gannon

    529 Plans: Educate Yourself Before You Invest Splash image

    We all want to get our money’s worth. This is true when it comes to paying for a college education—but it’s also true when it comes to investing for higher education.

    Since 1997, investors have had the opportunity to contribute to Section 529 college savings plans, which offer tax advantages that have made them a popular investment vehicle for saving for college. The good news is that there is no shortage of college savings plans to choose from—especially given the fact that in many cases you do not need to be a resident of a state to invest in that state’s college savings plan.

    However, selections should be made with care. Virtually no two plans are the same. Doing your 529 homework is essential because:

    • Contribution limits vary by state.

    • State tax advantages vary from state to state and may depend on whether you are a resident of the state sponsoring the plan.

    • Investment options vary greatly, from higher risk stock funds, to funds that contain a mix of stocks and bonds, to conservative investments that contain money market or conservative short-term bond funds. Most plans offer age- or enrollment-based investments that grow more conservative over time as the beneficiary gets closer to using the proceeds to pay for college expenses. Many plans also offer static investments where assets are typically invested in a set allocation of one or more mutual funds.

    • Fees and expenses vary greatly, even among plans offered within the same state.
    NASD (National Association of Securities Dealers) is concerned that investors may be shortchanging themselves by investing in 529 college savings plans with high fees, plans that currently do not offer them state tax benefits, or both.

    This article is designed to educate investors about 529 plans. It provides an overview of the plans, information concerning fees and expenses, and a specific caution about investing in out-of-state plans. It also provides eight easy lessons that, if followed, will help you make smart college savings plan choices.

    What Are 529 Plans?

    Named after the section of the federal tax code that governs them, 529 plans are tax-advantaged programs that help families save for college.

    There are two types of plans: prepaid-tuition plans and college savings plans. Every state offers at least one of these types of plans. However, this article focuses exclusively on the more than 80 state-sponsored college savings plans in which money is usually invested in a group of portfolios made up of mutual funds, and withdrawals can be used for college costs—including tuition, fees, room, board, textbooks, and even computers.

    How Plans Are Sold

    There are two ways that college savings plans can be sold to investors:

    • Direct-sold college savings plans: Investors buy an interest in the college savings plan directly from a broker-dealer on behalf of the state, the state that sponsors the plan, or from the plan’s program manager, with no sales person involved; and

    • Broker-sold college savings plans: Investors buy an interest in a college savings plan through an investment adviser, brokerage firm, or bank, generally paying a sales load or fee.
    The brokerage community has done a fine job of educating investors about the benefits of 529 investing, but investors should take heed:
    • Some brokerage firms and advisers offer only one or a very limited number of 529 plans. The options may not include your own state’s college savings plan and may not provide you the opportunity to invest in college savings plans issued by other states—even though those other 529 plans may have lower sales loads or lower expenses, or provide state tax advantages.

    • Broker-sold plans often contain sales loads and higher fees and expenses than direct-sold plans.

    State Tax Advantages Vary

    Federal tax advantages are a major benefit of investing in 529 plans. When you invest in a 529 plan, your earnings grow tax-free. Furthermore, withdrawals are also tax-free when used for qualified education expenses.(However, this exemption sunsets December 31, 2010, unless action is taken by the president and Congress to extend the provisions.)

    While federal tax advantages are standard to all college savings plans, state tax treatment of 529 plans varies from state to state and can be a factor in deciding which plan to select.

    In over 20 states (see Table 1), contributions are tax deductible if you’re a resident of the state sponsoring the 529 plan. Deductions vary from state to state. For example, Colorado currently allows residents to deduct the entire amount of their contribution to their in-state plan for each beneficiary, up to the amount of their gross annual income. Rhode Island, on the other hand, allows only a $1,000 deduction in total for joint filers and $500 for single filers.

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    Table 1. States Offering Tax Deductions or Credits to In-State Investors
    District of Columbia
    New Mexico
    New York
    Rhode Island
    South Carolina
    West Virginia

    Many states also follow the federal tax lead of allowing earnings to grow tax-free and imposing no state tax on qualified withdrawals from in-state and out-of-state plans.

    Several states impose taxes on qualified withdrawals from out-of-state plans and a few tax earnings on out-of-state plans.

    In an effort to keep money in its own state plan, New York even “recaptures” state income tax deductions that were given to state residents who move money from the New York college savings plan to a college savings plan in another state.

    In many cases, the smart move is to check out a plan in your home state—especially if your state allows you to deduct some or all of your 529 contributions. But always do the math to evaluate the value to you of any state tax benefit.

    The tax rules that apply to college investing options are complicated. Before investing, you may want to check with your tax advisor about the tax consequences of investing in college savings plans or read Internal Revenue Service Publication 970, Tax Benefits for Education.

    Compare Fees and Expenses

    All 529 college savings plans contain fees and expenses. These costs not only vary among 529 plans, but also can vary within a single 529 plan.

    Fees may include:

    • Enrollment charges,
    • Annual maintenance fees,
    • Sales loads,
    • Deferred sales charges paid when you withdraw your money,
    • Administration and management fees (often called the expense ratio), and
    • Underlying fund expenses.

    Needless to say, broker-sold plans often cost more than direct-sold plans. Typically, these additional costs take the form of front-end sales loads or other fees associated with share classes (described below), and annual distribution fees—including service fees that compensate the financial professional, who provides guidance in selecting a plan and managing your savings.

    Be Alert to Share Class Costs

    The decision process is made even more challenging because some broker-sold college savings plans, like some mutual funds, have different share classes. Often referred to as Class A, B, or C shares, each class has different fees and expenses (see Table 2). Inspect the offering document carefully with an eye to whether a particular college savings plan offers more than one class.

    Table 2. Cost Comparisons for College Savings Plan Share Classes
      Class A Class B Class C
    Front-End Load Initial sales charge. Canbe reduced or eliminatedby breakpoint discounts. None None
    Contingent Deferred Sales Charge (CDSC) None Declines over several years. Typically, CDSC is lowerthan Class B and iseliminated after 1 year.
    12b-1 Fees Typically, lower thanClass B and C shares. Typically, higher than Class A shares Typically, higher thanClass A shares.
    Converts to Class A Shares N/A Converts to Class A sharesafter several years, reducingexpenses thereafter. No. Annual expensesremain at Class C level.

    In many cases, in-state residents can avoid these extra expenses by buying the plan directly from the state. Some college savings plans even allow non-residents to avoid these extra expenses by buying shares in a direct-sold plan. However, if you buy directly from the state or its program manager, you won’t receive the assistance of a broker or financial professional, which may be important to you.

    The bottom line is that it pays to take the time to research all fees and expenses for each plan you are considering. Costs can quickly add up, diminishing any tax incentives a 529 plan may offer.

    Because fees and expenses can vary widely from plan to plan, NASD has developed a tool to help you compare how these fees and expenses can impact returns. The analyzer is designed to work with most college savings plans. It explains the various fees and provides guidance about where to find them in 529 disclosure documents. It also provides prompts that help ensure the best possible comparison between plans. You can find it at the NASD’s Web site (www.nasd.com) by going to the College Savings Center in the Investor Information section of the site.

    As a final warning, be wary of 529 plan ratings. Several Web sites and publications rate 529 plans and some states tout the rating their plans receive. Make sure you understand the basis for these ratings. Some third-party ratings systems appear to give little weight to state tax benefits or low expenses.

    8 Key Lessons

    Here are eight college savings plan lessons that, if followed, can help you make smarter choices:

    1. Start with your home state first when looking for a college savings plan. Pay special attention to state tax breaks and fees that are waived or lowered for in-state residents.

    2. Consider the plan’s investment options.

    3. Be aware that broker-sold plans are generally more expensive than direct-sold plans. If you’re comfortable going it alone, you can often save money investing in a direct-sold plan.

    4. Remember that one size does not fit all. Some brokerage firms and advisers offer only one or a very limited number of 529 plans. They may not provide investors the opportunity to invest in college savings plans issued by other states, even though those other 529 plans may have lower sales loads and lower expenses, may provide state tax advantages that are absent from the plans being offered, or may have better investment options.

    5. Ask questions. If you are investing on your own, call the toll-free numbers posted on the state-sponsored sites. If you are working with a broker or financial professional, don’t hesitate to ask these questions:
      • How many different college savings plans do you offer?
      • Can I claim a state-tax deduction on contributions to the college savings plan you’re recommending?
      • How much will I pay in fees and expenses?
      • Do the fees and expenses outstrip any tax savings I may achieve?
    6. Compare expenses, especially if your state offers both broker-sold and direct-sold plans and if you are considering investing in an out-of-state plan.

    7. Independently verify sales information you receive by thoroughly reading the official disclosure documentation.

    8. Make sure the investment meets your objectives and that you understand and are comfortable with the risks, costs, and liquidity of the investment. Never invest in a product you don’t understand.

    Consider a Variety of Options

    Finally, do not limit your research to college savings plans alone. There are a number of other tax-advantaged college savings options you can consider. These include:

    • Prepaid tuition plans
    • Educational saving accounts
    • Custodial accounts
    • Savings bonds

    For more information on college savings plans and other college savings options, check out the Web sites listed in Table 3.

    Click on the College Savings Center link in the Investor Information section of the Web site. Provides information on 529 plans, as well as other methods of financing higher education. Site includes an Expense Analyzer to help compare the total costs of various plans.

    College Savings Plans Network (CSPN)
    The Network is a clearinghouse for information among existing college savings plans. Provides a brief description of all state plans (listed by state) and includes links to state plan Web sites.

    Comprehensive commercial site for college savings plans and financing a higher education. Provides details on each state’s plans and also allows you to search for plans by state, investment manager and plan type (broker sold or direct).

    Internal Revenue Service Publication 970
    This publication, Tax Benefits for Education, is the official IRS word on the tax rules regarding 529 plans.

       Table 3. Financing an Education: Where to Go for More Information
    NASD’s Smart Saving for College

    John Gannon .


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