States Beef Up Their College Savings Plans

If you haven't heard of college savings 529 plans, chances are you will soon. Competition in the 529 market is heating up, and a number of leading fund companies have signed up with 44 states to offer these tax-deferred, state-sponsored savings plans.

While today's 529 plans, which are named for the section of the IRS tax code that created them, are certainly improved with more and more aggressive investment choices than before, investment advisers still say that financial aid and taxes make 529 plans advantageous only for the wealthy.

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The 529 plans have their roots in prepaid college savings plans that states offered to guarantee college tuition tomorrow at today's rates. Because of their guarantees, states managed them very conservatively, though, with ultra conservative investments. They were also unappealing because they locked a family into choosing a particular state college years ahead of the child reaching college age.

Today, 44 states offer 529s with as many as five investment portfolios, some of them 100% invested in equities. And even the age-based portfolios that increase fixed-income investments and lower equity investments as a child ages, are more aggressively invested in equities. A year ago, by contrast, only 34 states offered 529s, and many offered only one investment portfolio, typically with a heavy emphasis on bonds.

Now that there are more 529 choices, even the financial planners who specialize in college savings say they're difficult to sort through. However, they do offer some tips on what you should consider before you invest in a 529.

The Basic Info

College saving 529 plans are sponsored by individual states, but you're generally free to invest in any state's 529 plan and spend the money at any accredited college, graduate or vocational school anywhere in the U.S. The money grows tax deferred, which means you don't pay any federal or state taxes until you start drawing it down, at which time earnings are taxed at your beneficiary's rate.

These 529s also give you control that Uniform Gift to Minors Accounts, or UGMAs, and Uniform Transfer to Minors Accounts, or UTMAs, don't. The person who takes out a 529 account for a beneficiary controls the money when the youngster reaches maturity at 18 or 21. "This way, you don't have to worry if the child is going to choose a Harley over Harvard," says Richard Davies, executive vice president and managing director at Alliance, which sponsors Rhode Island's 529 plan.

State Tax Breaks

If you're interested in a 529 plan, the best place to start is by looking at the plan in your own state because many states offer additional tax breaks for residents, says Joseph Hurley, CEO of savingforcollege.com.

Some states now let families deduct the full or a partial amount of their contribution from their state taxes, according to the College Savings Plan Network, a clearinghouse of the state treasurers overseeing 529 plans. Further, most exempt earnings in the plan from state income tax.

Hurley believes the federal government might eventually make 529s completely tax-free. If that happens, the $10 billion currently invested in 529 savings plans could far surpass the $100 billion Hurley projects for 529s by 2010.

The Downsides

Though these benefits may sound good, there can be significant drawbacks to these plans.

"If you are eligible for financial aid, then 529 plans are very, very negative," says Raymond Loewe, president of College Money, a financial planning company that specializes in college savings. "When money is drawn out of a 529 plan to pay for tuition, the earnings portion is considered income for the student. This reduces a student's financial aid by 50% since financial aid formulas reduce a student's financial aid by 50 cents on the dollar."

Families earning $75,000 or less can typically qualify for financial aid at a private college, and families earning $50,000 or less typically qualify at a public college, Loewe says.

"Of course, saving for college through UGMAs, UTMAs, mutual funds and securities can have a negative impact on financial aid, as well -- in many cases worse than a 529 plan," Loewe adds. "But financial aid is a consideration a family should weigh before investing in a 529."

In addition, beneficiary tax breaks in 529s don't always work out so well for families in lower tax brackets, Loewe says. "Generally we tell people if you are in a 31% tax bracket or higher, you want to look at 529s, but if you are in a 15% bracket or near it, you probably don't," Loewe says. That's because they'll get taxed at the same amount as their children, and they'll have more flexibility with that money if they invest it on their own. At the same time, though, there's something to be said for a plan that helps you save and only allows you to spend that money for your childrens' college education.

More Investment Options

But 529 plans have improved to offer as many as five portfolio choices, many of which are more aggressive than before. "First-generation plans were painfully conservative and just did not appeal to investors," says Davies of Alliance.

It's especially important that you like the investment options in your 529 plan, because once you select one, you cannot change it, notes Kalman Chaney, president of Campus Consultants. Of course, it's possible to roll a plan over to another beneficiary in order to move the money into another investment, but that's cumbersome, says Hurley.

Because of the investment restriction, age-based portfolios may still make the most sense even though parents have been clamoring for more aggressive, 100% equity portfolios, financial planners agree. Fund companies typically start out these age-based portfolios at aggressive, 80%-100% equity levels for a newborn, and gradually shift more of the money into fixed income as the child reaches college age. In fact, in the 12 states where TIAA-CREF manages 529 plans, age-based portfolios have continued to be the more popular investments, despite the many different investment choices TIAA-CREF now offers, says Timothy Lane, vice president in charge of tuition finance at TIAA-CREF.

Unfortunately, there's no Morningstar-type clearinghouse to compare 529 performance, and most 529 investments are only one or two years old. However, most of the portfolios in these plans are invested in existing funds, or clones of existing funds, so it's possible to ask fund companies for comparable performance figures with longer track records, Hurley says.

Investment Caps, Fees

If you figure you have the disposable income to invest in a 529 plan, you may want to shop around for one that will allow large investments over the plan's lifetime. Alliance's CollegeBoundfund program in Rhode Island permits a total of $246,000. New Mexico's plan, managed by State Street Global Advisors' subsidiary Schoolhouse Capital, allows $160,000.

Conversely, you should also figure out what minimum investments you must commit to in a 529 plan, suggests Kalman Chaney, president of Campus Consultants. "If you suddenly can't pay, they could stop you from participating anymore," he says.

Finally, it's important to look at fees and service, even though it may be hard to unearth those fees because they're not always openly disclosed, according to Chaney. Fees range from 0.30% to 1.80%, he says.

Customer service also leaves much to be desired in some states, says Ralph Constantino, CEO of Schoolhouse Capital. It tends to be better in states where a fund company, rather than state administrators, service customers, he says.

Tuition North of $100,000

Last but not least, don't forget to figure out how much you'll need. Taking tuition, room, board, books and "pizza money" into consideration, state universities today easily run $50,000 for four years, while Ivy Leagues cost about $150,000, says Loewe of College Money.

For a child born in 2001, those costs are projected to become $130,000 at a public and $320,000 at a private college, according to Mike Saliba, director of 529 plans at Mercury Funds, a subsidiary of Merrill Lynch that sponsors 529 plans in Arkansas and Wyoming

"It's daunting to think that a family with two children could be looking at college tuition in the $500,000 range," Saliba says.

That's all the more reason, financial advisors say, to get started in a 529 or some other college savings plan today.

For More Information:

The College Savings Plan Network, the clearinghouse of state treasurers overseeing 529 plans, offers basic information and links to each state's 529 plan.

Joseph Hurley, author of The Best Way to Save for College (BonaCom Publications, Pittsford, N.Y., 2000 edition), runs a Web site that gives key overviews of 529 plans.