A Costly Lesson in College Savings

There's no question that families can use help. The cost of college continues to outstrip inflation, according to the not-for-profit College Board. In 2003-04, the average cost of tuition and fees, excluding room, board and incidentals, at a private college was $19,710, up 6% from the previous year, and $4,694 for a four-year public college, up 14.1%.

Named for a section of the Internal Revenue Service code, 529s are state-run programs that offer hefty federal income tax breaks. In the past four years, they have grown from $10 billion to $47 billion in assets, with 6.1 million individual accounts. Families can choose plans from any of the 50 states and the District of Columbia.

With so much choice and competition, it should be a consumer's paradise. Instead, it is a morass whose investment funds, tax incentives and tangled rules and regulations are enough to baffle experts and probing financial journalists.

"I have a law degree and a Ph.D., have studied these state programs since their early versions, have written two books on the subject, own contracts in five states, and still cannot compare the plans across various states," admitted Michael A. Olivas, a law professor at the University of Houston, in testimony before a House of Representatives subcommittee earlier this month.

The fund's biggest problems occurred because 529s are run by individual states and regulated by the Municipal Securities Rulemaking Board (MSRB), critics say. However, most plans are made up of mutual funds, which are regulated by the SEC under far stricter federal investment laws, and all 529s receive the generous federal tax benefits. Yet the SEC currently has only indirect oversight of plan investments, by regulating the financial advisers who sell them.

Faced with the threat of federal regulation, the chair of the association of state plans pledged before the same congressional subcommittee that the states could regulate themselves and would provide consumers with standardized information allowing state-by-state comparisons. On June 10, the MSRB said it was proposing to upgrade rules on disclosure, advertising and performance of 529s to bring them more in line with SEC investment regulations, and would take comments until Sept. 15.

Dan McNeela, a Morningstar senior analyst, said he doubts the states will do a good job reforming the plans on their own: "It's not in their best interests to reveal they're not the best plans out there."

Nevertheless, since Congress endowed 529s with generous tax advantages in 1996, the plans have been the darlings of money advisors and the financial media. As long as funds withdrawn from 529 accounts are used for educational expenses, plan participants owe no federal income taxes on the earnings. Some states also waive their income taxes or offer tax credits.

With their large contribution allowances and ease of parental control, they are, in principal at least, superior to other college savings options, such as the Coverdell Education Savings Accounts and UGMA (Uniform Gifts to Minors Act) accounts, once the college savings method of choice. Click here to learn more about the alternatives to 529s.

So, what went wrong?

States' Rights

Simply put: In their new roles as 529 plan sponsors, some states picked lousy and even negligent fund advisers to manage their plans, and others have succumbed to boosterism.

Coincidentally enough, two firms that manage 529 plans figured prominently in the mutual fund trading scandal that began last year.

Putnam Investments, a Boston-based unit of Marsh & McLennan (MMC Quote), which manages Ohio CollegeAdvantage 529 Savings Plan, recently settled federal allegations stemming from the scandal. The company agreed that it was grossly negligent for letting at least six managers engage in short-term trading in their personal accounts.