A Costly Lesson in College Savings

"It's a good time to be warning people in age-based plans that their returns may be flat or negative," he said. While there is time to weather market ups and downs from equity investments in age-based funds when children are young, the funds rely most heavily on bond investments several years before college, just when families count on having their principal intact.

Olver said that families of older teens can switch to stable-value funds such as those offered by TIAA-CREF. With 529s, as a rule of thumb, he avoids bond funds whose average maturity, or average length of time until the bonds held mature, exceeds the time before the money is needed. In other words, if the money is required for college in 2008, consumers should steer clear of bond funds whose weighted average, sometimes known as duration, is longer than four years.

Rags to Riches

College 529 plans had a humble beginning, tracing their origins to a prepaid tuition contract created in the state of Michigan in 1986. That eventually led to an addition in the U.S. tax code in 1996, Section 529, allowing certain state tuition programs to defer federal taxes on participants' income.

At the time, families saving for college through the dozen or so 529 plans available, could earn money tax deferred.

Then a 1991 tax-law change dramatically altered the fortunes of the 529. Earnings could thereafter be withdrawn free of federal taxes if used for qualified education expenses, such as tuition, books and room and board.

Because anyone can contribute to a 529 regardless of income and because multiple donors can contribute to the same child or children, the accounts were seen as a bonanza for the upper-middle class and the wealthy. Investment advisers targeted grandparents with substantial assets as likely donors, because they can remove large amounts from their estates while still maintaining control of them.

Donors decide how to invest the money, and can even change beneficiaries from one child to another, if one winds up not attending college, or to another family member. If, however, the money is not used for education expenses, it is taxed to the recipient and subject to a federal 10% tax penalty.

Ironically, given all the hoopla surrounding 529s, their future is in question. The federal tax-free status on earnings is scheduled by law to sunset in 2011, unless Congress acts before then to renew it. Experts told the subcommittee that unless the tax benefit is made permanent soon, uncertainty could begin curbing plan popularity.

Meanwhile, the tax law passed in 2003 that reduced tax rates on capital gains and dividends through 2008 has made 529s less compelling to some affluent families as sources of college funding (see related story).

In his budget for 2005, President Bush has again proposed creation of personal savings accounts that could be used for both retirement and college savings. If these tax-enhanced accounts come to pass, 529s could be pushed into the background or eliminated altogether.

McCrae, the Ohio plan investor and a cancer physician in Cleveland, said his children, now 16 and 13, are well set for college, with about $160,000 each in their 529s plans.

He was able to get his two children's college savings on track only after he spent many hours researching plans online. His frustration in trying to choose led him to drop the adviser who recommended the commissioned, high-fee, home-state plan and switch to Olver's fee-only financial planning firm.

In 2002, when McCrae's wife was dying of cancer, the firm recommended that he and his wife each make use of one of the 529's best features: the ability to contribute $55,000 to an individual 529 beneficiary in one year without triggering a gift tax event. (The $55,000 equals five times the usual $11,000 IRS limit one individual can give to another each year without tax consequence.)

McCrae now has 529 plans in several different states, including Alaska's Equity Option managed by T. Rowe Price and TIAA-CREF's guaranteed options in Missouri and Minnesota.

Olver said that before he felt capable of recommending 529s to clients, he spent months doing "due diligence" on state plans and feeling thwarted by the lack of disclosure.

"It's not all in one place," he said. "It's not all the same language. I can't imagine an individual investor, on his own, going out there and finding the best option."

A Costly Lesson How the Best and Worst 529 Plans Rate
State/Name of Plan	Primary Fund Provider	Asset-based Costs	Asset-based Range (%)	Quality of Core Investment Options	Investment Flexibility	Shareholder Friendliness
Best 529 Savings Plans
Utah Educational Savings Plan Trust	Vanguard	Low	(0.00-0.44)	Excellent	Good	Excellent
Nevada Vanguard 529 College Savings Plan	Vanguard	Low	(0.65-0.85)	Excellent	Excellent	Excellent
Virginia CollegeAmerica	American	Below Avg.	(0.67-1.47)1	Excellent	Excellent	Excellent
Michigan Education Savings Program	TIAA-CREF	Low	(0.65)	Good	Fair	Good
Alaska T. Rowe Price College Savings Plan	T. Rowe Price	Below Avg.	(0.65-1.27)	Excellent	Good	Excellent
Worst 529 Savings Plans
Wisconsin EdVest College Savings Program	Strong	Above Avg.	(0.50-1.71) 2	Fair	Good	Poor
Arizona Waddell & Reed InvestEd Plan	Waddell & Reed	High	(2.21-2.64) 1	Good	Poor	Fair
Arizona Family College Savings Program	SM&R/Alger	High	(0.73-2.10) 2	Poor	Poor	Poor
Wyoming 529 College Achievement Plan	Merrill Lynch/MFS	High	(1.80-2.90) 2	Fair	Fair	Fair
Ohio Putnam CollegeAdvantage Savings	Putnam	High	(1.10-1.89) 1	Fair	Excellent	Poor
1 Cost for class A shares, not including front-end load. 2 Plan is available directly and through brokers.
Source: Morningstar Fund Investor