Tax-free college savings 529 plans now have $60 billion invested in them -- a clear sign that proper savings incentives do work. These plans allow money to grow and be withdrawn tax-free for use for college expenses at any school, in any state, for any child in the family.
The plans got a boost from the Deficit Reduction Act, which was passed last week. The bill made it clear that these investments are not to be considered assets of the student, which count more heavily against the family in the financial aid process.
But there are uncertainties surrounding 529 plans that have slowed the flow of money into these valuable savings alternatives. For one, there are doubts that the accounts will be around after 2010. The way the current law is written, the ability to withdraw earnings tax-free will disappear in 2011. In addition, it's difficult to sort out the variety of state tax incentives that surround the plans.
With Congress set to debate the extension of the tax legislation, it's time that parents and grandparents of future college students understand the issues -- and make their concerns known. Everyone else has a "lobby" in Congress and state legislatures. Why not parents?
First, parents need to understand how the two types of 529 plans work, and the political issues involved.
Prepaid tuition plans: These 529 plans allow parents (or grandparents or family friends) to purchase tomorrow's tuition at today's prices. There's minimal risk, since states guarantee that no matter what happens to tuition prices, the child is guaranteed the number of semesters purchased for use at a public university or community college in the state. (Assets can be transferred for use in other schools, but they aren't guaranteed to keep up with the pace of tuition increases.)
Savings investment plans: In this type of 529 plan, the growth in college money depends on the investments made in funds offered within the plan. Typically, there is a choice of stock funds and a shorter-term bond fund. Most plans also offer "age-based" accounts, where the fund managers choose the investments and become more conservative as the child gets closer to needing the money for college.
You can learn more about how 529s work
The legislation for 529s allows each state to create its own plans, which are typically housed under the state treasurer's control. The chosen fund management companies share fees with the state based on the amount of assets in the plan. Thus, there's an incentive for states to offer tax breaks on investments and withdrawals in order to grow the plans.
Each state also sets its own fee and commission structure. Accounts may be opened without commissions if the application is made directly through the state plan's Web site. But financial advisers may sell the same plan and earn a commission of around 4 percentage points. The argument for the extra cost is that brokers and planners provide a valuable service in explaining and encouraging these investments. In fact, about 80% of 529 sales are made through the broker/planner community.
Lately, federal regulators, in the interest of consumer protection, are requiring that brokers explain not only fees, commissions, and ongoing costs in the plan they're selling -- but also describe the tax incentives by comparing
state plans. It's an overwhelming job, made more difficult by the wide range of issues, so plan sales are stalling.
There's one more issue that makes it difficult to compare 529 investment plans: There's no required performance reporting and no standardized age brackets. So there's no basis for making after-cost performance comparisons.
One excellent Web site,
SavingforCollege.com, does allow you to compare plan features. But only Morningstar is attempting the difficult task of comparing performance and costs.
In the latest Morningstar FundInvestor Newsletter, analyst Kerry O'Boyle rates the Alaska plan, run by
T. Rowe Price
, and the Utah plan, which has investments in
funds, the tops in being both low-cost and having "sound asset allocation" strategies. Among the worst, according to Morningstar, are some of the Nebraska plans, along with plans in Arizona, Alabama, North Dakota and North Carolina.
So what should concerned parents be demanding now? College 529 plans were created with the right structure and the right incentives. But the concept would be even more useful with long-term extension of 529 legislation; required annual (after-cost) results reporting, along with standardized age brackets; and equal state tax incentives, no matter which plan is used.
It's possible that a proposal extending the tax-free treatment of 529 plans will be attached to upcoming pension legislation. Or it may have to wait for the eventual tax bill that deals with other issues containing "sunset" provisions, such as estate taxes. But it would be a shame if education incentives got caught up in the political wrangling over more controversial tax issues.
Parents, it's time to get involved. First, we need to make sure that the plans will be around for many years to come. Then, if states offer the same tax treatment to any 529 plan investor, and if plans can easily be compared based on performance, we'll have the right incentives to reach the very important goal of educating our children. That's the Savage Truth.
Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column by the Chicago Sun-Times is nationally syndicated, and she released her fourth book, The Savage Number: How Much Money Do You Need? in June 2005. Savage also was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. A Phi Beta Kappa graduate of the University of Michigan, Savage currently serves as a director of the Chicago Mercantile Exchange Corp. She also has served on the boards of the McDonald's and Pennzoil corporations.