Save for college and reap big tax breaks under a 529 plan. What's not to like?

Ask Keith McCrae, a 47-year-old father of two who took the 529 plunge three years ago. At the time, his home state of Ohio was rolling out its version of the mutual fund-style accounts designed to help families with college-bound children. His financial adviser was only too happy to sign him up.

But he didn't read the fine print -- until after he'd handed over his money.

Closer scrutiny revealed fees of 2.5% a year on the plan -- almost assuring mediocre, and possibly even negative, returns on his funds. Had he known about the high fees, McCrae never would have selected the 529 plan from Ohio, recently named one of the worst performing programs in the nation by the rating service Morningstar.

"I should have done my homework first," he said.

While McCrae takes some of the blame, a growing chorus of federal legislators, regulators and financial analysts are faulting the popular savings plans for a host of investment sins, namely exorbitant fees and commissions, lack of disclosure, poor performance and needless, overwhelming complexity.

If that isn't enough, with interest rates now on the rise, financial advisers also warn that the most popular type of 529, known as an age-based plan, could be a ticking time bomb. The plans for students nearing college are often heavily weighted in bonds, which could suffer big losses if rates continue to rise. Given the sophistication and perseverance needed to track the fund assets, advisers say, typical contributors could be blindsided by mediocre returns or loss of principal when they most need it.

No surprise then, that the plans are now the focus of two congressional hearings, a

Securities and Exchange Commission

task force and a securities industry regulatory investigation. Indeed, 529s are joining mutual funds and insurance annuities as the latest investment vehicle to be denounced for putting the interests of financial-service providers ahead of the consumers they were intended to help.

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) - Get Report

, 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.

Last month, the Ohio Tuition Trust Authority, which oversees the plan, was named the lead plaintiff in a lawsuit to recover money from Putnam for alleged market timing deemed detrimental to long-term investors.

Strong Capital Management of Menomonee Falls, Wis., which has managed 529 funds in Wisconsin, Oregon and Nevada, and its founder and CEO also have settled federal allegations of abusive trading. The company has since agreed to be purchased by

Wells Fargo

(WFC) - Get Report

.

Political considerations might influence how 529 managers are chosen, says Mercer Bullard, an assistant professor of law at the University of Mississippi and president of a nonprofit, mutual fund shareholder advocacy group called Fund Democracy. At the congressional hearing, he cited the cases of Wisconsin, which chose state-based Strong, and Maryland, which selected Baltimore-based

T. Rowe Price

(TROW) - Get Report

, a fund family rated highly for its Alaska 529 plan.

The SEC recently noted that the states generally don't appear to disclose to investors in writing how they select managers for their 529 plans.

Most states follow a rigorous procurement process in choosing to partner with a financial institution for a 529 plan, according to Diana Cantor, executive director of the Virginia College Savings Plan and chairwoman of the College Savings Plans Network, the association of state 529 plans.

Bullard, however, has urged Congress to require the SEC to regulate 529s immediately, arguing that they have conflicts of interest that cannot be overcome. Already, he said, they have demonstrated their willingness to gouge out-of-state participants with high fees, commissions and lack of disclosure to the benefit of their own residents. Perks can include lower fees, state income tax breaks in many cases and even scholarship monies for needy student residents funded directly from plan fees.

Critics say that the uneven rules, tax deductions in some states but not others and tax penalties for switching states, can make some consumers captive to home-state plans. McNeela pointed to Wisconsin residents invested in the state's 529 plan, run by scandal-ridden

Strong Capital

, which saddled them with above-average costs and subpar management. They're forced either to wait for improvement or exit the plan and sacrifice their state tax deductions.

Fee Frenzy

Many plans charge a slew of fees. Their exact names may vary but they usually include a one-time enrollment fee, ongoing account-maintenance fees, administrative fees and management fees, and in many cases, broker fees or commissions.

While 1% or 2% in annual fees might seem minuscule to uninformed investors, McNeela of Morningstar says that when combined with brokers' commissions, they can consume as much as one-third of an investor's potential gains, assuming a 6% average annual return.

"In short, too many 529 plans are prohibitively expensive," McNeela told the subcommittee.

Growing concerns about high 529 fees are the reason Rep. Michael G. Oxley (R., Ohio), chairman of the U.S. House of Representatives Committee on Financial Services, convened the June 2 subcommittee hearing. In a Feb. 4 letter to William H. Donaldson, chairman of the SEC, Oxley questioned whether the many fees in some plans offset the tax benefits Congress granted to help families save for college.

Donaldson quickly set up a 529 task force. While the SEC does not regulate 529s directly because they are operated by the states, it does have control over the brokers, dealers and advisers who sell the underlying investments.

Responding to Oxley, the SEC confirmed what outside analysts already had concluded: that in some situations, a 529's high fees could in fact negate the tax benefit.

The agency also offered an illustration of how much of an impact fees can have on 529 investment performance. It compared the cost of investing $10,000 in the low-cost Utah Educational Plan Trust and the same amount in the similar but higher-cost Rhode Island JPMorgan Higher Education Plan for 18 years, assuming an 8% annual return. Over the period, the Utah plan would yield $7,728 more, for an eye-popping difference of 20.7%.

Last month, Putnam cut fees on its 529 plans. On May 24, Ohio added funds by the respected low-cost mutual fund Vanguard Group as an alternative.

Commission-Crazy

An estimated 80% of the money invested in 529s arrives via an army of stock brokers and financial advisers who are paid commissions as high as 5.75% of the funds invested. Plans listed as paying that top commission have included Pennsylvania's TAP 529 Investment Plan managed by

Delaware Investments

, and one of Nevada's several plans, the American Skandia College Savings Program managed by Strong.

Bob Veres, editor and publisher of

Inside Information

, a newsletter for financial advisers, says if states really put consumers first when selecting 529 managers, then each would offer the low-cost Vanguard or TIAA-CREF family of mutual funds, which can be purchased without brokers and commissions.

"Somehow, some way, the states have opted for the dark side," he said.

Joe Hurley, a Pittsford, N.Y., CPA and national authority on 529s, defended the use of sales forces. "Brokers are introducing 529 plans to people who wouldn't otherwise make the effort," he said.

Hurley's Web site, www.savingforcollege.com, contains a wealth of information and serves both consumers and advisers. Families can sign up to get names of advisers who work in their area under a section entitled "Find a 529 pro in your zip code." The site, however, states it cannot vouch for the advisers, who pay a minimum $495 annually for the listing and must first pass a test on 529s.

Bob Levy, an employment law attorney with a large Southern California firm, said he didn't mind paying a commission to invest through a friend, who happens to be an Allstate agent, in Virginia's highly rated 529 plan, managed by

American Funds

.

"This looked like a wonderful vehicle," Levy said, "but I didn't have the whole thing nailed. The key is getting the money in there and letting it go to work." His son was already in high school and time was running out, so he chose an option in which the commission was reduced the longer he held the account.

Disclosure vs. Deceit

Some state plans are dysfunctional or downright evasive when it comes to disclosing important information to investors, information that federal regulations routinely require of mutual funds.

The

National Association of Securities Dealers

is investigating whether 15 broker-dealers sold 529 plans to out-of-state residents without disclosing that the prospective investors would lose income tax deductions by not selecting their home-state plans instead.

Some 529 managers do as much as 90% of their business with customers from other states, according to an NASD spokeswoman. It is not illegal for a state plan to sell to out-of-state customers. At issue is whether the recommendations were suitable and customers knew their options, as well as the consequences of their decisions.

Because of the exemption from SEC regulation, 529s are not subject to the same fee-disclosure requirements as other investment products, like mutual funds, which actually make up most college savings plans. In most cases, the fees are difficult to find, according to Bullard of Fund Democracy.

In Maine's 88-page NextGen College Investing Plan, for example, a difficult-to-decipher discussion of fees doesn't crop up until page 43. Alaska's Manulife College Savings Plan doesn't broach the touchy subject until page 45 of its 61-page disclosure document, Bullard noted.

"At its worst, the complexity of the cost structure and the reluctance to make the information easily accessible amount to deceit on the part of 529 providers," McNeela told subcommittee members at the recent hearing.

Susan Dynarski, an assistant professor at the Harvard University Kennedy School of Government who specializes in tax and education policy, recently assigned a student to compare the fees charged by all of the 529 plans.

Dynarski called a halt to the assignment, however, because with so many fees with so many different names, there was virtually no way to compare them. "If a Harvard undergraduate cannot comprehend the fees," she said, "then something needs to be done."

She holds little hope that the average American family struggling to work and raise children can find the wherewithal to comparison-shop 529 plans.

Hidden Performance

Most 529 plan options consist of funds run by the major mutual fund companies. Yet consumers have no quick or easy means to compare performance as they can with mutual funds.

An estimated $2.8 billion has been invested in Putnam funds through Ohio's CollegeAdvantage plan, which offers more than a dozen options and reflects as many as six commission fee structures. Many of its age-based funds, a popular 529 investment mix that reduces exposure to stocks and increases bonds and fixed income as a child ages, are showing minuscule or negative returns.

For example, the fund geared for children born in 2000 has lost, depending on the fee structure, between 0.94% and 2.05% annually for the past three years ending April 30, according to Morningstar. For students born in 1986 and about to enter college, the fund has earned, depending on fees, between 0.11% and 1.67% annually for the same period. By comparison, TIAA-CREF offers a stable-value fund that guarantees no loss of principal and is currently paying about 3% annually.

While 529 participants currently receive performance information on individual investments, they should see the performance of comparable benchmark investments next to their own funds to understand how well -- or poorly -- their investments are doing, said McNeela.

"If this is done properly," he said, "plans saddled with poorly performing funds and high cost structures will have few places to hide."

Morningstar maintains a database on 529s plans, which it recently used to rank the best and worst plans for consumers based on several features, including quality of investment options. (See chart at end of this story.)

But the firm doesn't supply performance data on its free www.morningstar.com Web site. Greater detail on plan options and performance, however, is available on its paid Web site for advisers, for an additional annual fee of $495.

Bond Bombshells

Many families choose to invest in age-based funds -- usually a mixture of several mutual funds. These funds contain more stocks when children are young, then shift to bonds and cash as they near college age, mirroring a classic investment strategy of capital growth in the early stage and capital protection in the late stage.

But now, with interest rates rising from their lowest point in four decades, some of these age-based plans could generate an unwelcome, unexpected and unprofitable outcome for families with high-school age students, according to some financial advisers. That's because bond prices fall as interest rates rise.

If an age-based plan for older children is heavily laden with bonds, particularly with the wrong kind of maturities, "People will see their principal erode," said Candace Bahr, a managing partner with Bahr Investment Group in Carlsbad, Calif. "People are going to be blindsided."

Matthew S. Olver, a certified financial planner with Spero-Smith Investment Advisers in Cleveland, said that some bond funds contained in age-based plans already are starting to lose money. If interest rates continue to rise, the losses will increase.

"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."