Paying for college just got easier, thanks to a federal tax break that goes into effect this year. Under the rules, parents can now make tax-free
withdrawals from state-sponsored college savings accounts known as 529 plans.
Even though the deal is bound to attract new investors, some may be overwhelmed by the variety of choices. Forty states now offer 529 college savings plans, with most open to people residing anywhere in the U.S., according to Savingforcollege.com, a reference site on 529s. (
Click here for an updated chart of available state plans and residency requirements).
Taxes in 2002: Investing for Education
Taxes in 2002: Retirement Plans
Taxes in 2002: Estate Planning
To help make sense of the options, we spoke to Kevin Rex, a financial planner and principal at Summit Financial Resources in Parsippany, N.J., who frequently advises clients on the subject. Below, he explains what investors should look for in a 529 and names three of his own favorite plans.
Q: It seems like 529s are going to be a huge deal. Can you comment on the level of interest and the significance of the new tax changes?
A: The level of interest is extremely high once people are educated that the new law exists and how it works. I might, for instance, be doing a seminar, and if half the people in the room know about it and the other half don't, the half that don't know are pleasantly shocked that such a good and useful law exists. They are very happy to learn about it. The level of interest is about as high as I've ever seen in terms of a new product, or in this case, a new tax law.
Q: Did many people that you worked with invest in 529s before now, or was it off their radar screen?
A: What has happened here is the tax law we have now on the 529 plan is actually the third generation of this tax law. The first generation of it was extremely restrictive and not so popular, for good reason. I'd say that was in the early to mid-90s.
Under the earlier version of the plan, you had to go to school in that particular state, and for that reason, there wasn't a whole lot of interest.
With the second version, you could go to school in any state and reside in any state. That was good, but the tax benefits weren't as generous as they are today. If you look at the second-generation tax benefits, the money would grow, tax deferred, but when you pulled the money out, you would have to pay taxes.
Q: You'd have to pay taxes at the student rate, and that was typically 15 percent, right?
A: Yes. Under the third generation there are no taxes on the growth or on the withdrawal. Also, the third generation of this tax law really opens the definition of education. It pretty much includes everything except transportation. Things like room and board, even books and computers and things of that nature would be covered under this plan. What is not covered is transportation to and from.
Q: These plans are also pretty flexible, right? So if I think I want to go to graduate school, for example, can I open one for myself and if I later change my mind, decide to use it for something else?
A: Yes, absolutely. You can open one for yourself to go to grad school, and let's say you change your mind. In the future, you can actually change the beneficiary of that to give it to your future children, your nieces or nephews, or whomever you might want to give it to.
Q: I've been looking on different Web sites that link to all the plans out there, and I'm wondering how do you even get started? There are so many different plans.
A: You are dealing with the different states, so you have to evaluate the money managers that they've linked on with. If you pick the Massachusetts plan or the New Hampshire plan, you're largely picking that for the managers.
In some cases it's the state government -- employees of the state government, internal employees who manage the plan. The rap on the states that use their own treasury department is that they tend to be very conservative in their investments, perhaps a bit too conservative.
But one of the things I tell my clients is that this is not an irreversible decision. If you picked the New Jersey plan and you want to switch to the New York plan, you can do so. You can actually switch to another state. It's not very different from rolling an IRA at Merrill Lynch to an IRA at Schwab, for example. It's not a life-long irreversible decision.
Q: In some cases, states offer extra benefits to their residents. So should you look first in your own state?
A: Absolutely. One of the attractive things about the New York plan, which New Jersey does not have, is on the New York plan for the first $10,000 of contributions per year
for married couples filing jointly, you actually get a state income tax deduction -- state only. That's $10,000 total, not $10,000 per child.
I'm not crazy about the choice of money managers on the New York plan
TIAA CREF, but it's hard to walk away from a state tax deduction. I have clients who have funded large dollars into a 529 plan who are New York state residents. I put some in the New York state plan for the state tax deduction, and then I set up a separate account in a different state.
Q: What are some of the other factors that may differentiate plans? What about expenses? Is there much of a range there?
A: There is, but the range is usually more a function of whether you're using the state treasury department or TIAA CREF, or a high-profile money manager. If you are rating cost, and only cost across the board, of course a plan that has plain-vanilla indexes or uses the state treasury department would have the advantage of having a typically lower cost.
If you want a top money manager managing your money, they would have higher costs, but you are getting the money managers with the track records vs. the state treasury department. I would caution investors not to look at this from only a cost standpoint.
Another thing we look at is ease of administration. You have to realize, if you invest in a 529 plan, you are dealing with some bureaucracy. This is not money in your account. When you need that tuition paid, they actually cut the check to the school for you. You need ease of administration to get through the bureaucracy. That would be another thing we tell people to look at -- ease of administration, how user friendly it is.
Another thing we look at is that different states have different bells and whistles. I'll give you an example: some states will actually say you can cover college, graduate school and you can cover certain adult education classes. Some states, in their allowable schools to cut tuition checks to, include golf schools. Some give you a whole lot more bells and whistles.
Q: Can you mention some plans that don't measure up well on these factors, the ease of administration for example? Which plans are not very user friendly?
A: From the feedback I've received from clients, I'd say the local states like New York and New Jersey.
Q: Is there some sort of standardized performance record to see how the plans have done over the last three or five years? How do you compare the performance across different plans?
A: At this point, we don't have a long-standing track record that runs through various market cycles to see how various money managers did. You really have to rely more on the reputations of the money managers that the states are using. They only have two- or three-year track records.
Q: Does every state post its numbers in a different format, then?
A: Unfortunately, there is really no standard. The reason is many of the states offer what's called a lifestyle product. The lifestyle product is sort of a benchmark to the number of years that you have until the tuition is due. A 2-year-old on a lifestyle product would be more growth-oriented in the way they manage the money. Now as the 2-year-old becomes 17, that will shift over to fixed-income and cash positions. It gets more conservative as you get closer to the event. Most of the programs have a lifestyle product.
Q: Are the lifestyle options pretty popular with your clients?
A: Sure they are, because it puts it on overdrive. If you use the lifestyle product, they will get more conservative over time as you get closer to cutting the tuition checks, but you'll have a good hedge for growth during the double-digit years.
Q: So if I go to a state's 529 plan Web site, can I expect to find some performance numbers?
A: Yes, you should be able to. The thing about performance numbers is, if you look at the last two years, they were just horrible market years. So far in the 529 plans, we have not really focused on those short-term returns. You're only looking at one market cycle, and that's a bear market. Just looking at returns doesn't tell a full story. The better returns will be the plans that are more conservatively invested.
That doesn't mean that over the haul of time, if they've done better over the last two years, that they'll do better over the next 10. When you compare investments to other investments, you have to try to make the comparison through a variety of market cycles.
The point I'm making is that if you only look back at the last couple of years, you only see what that manager did over a bear market cycle. That doesn't show you what the manager would do under a sideways market or an up market.
Q: How do you find out what your plan is? Do you call your state treasurer? Or I suppose you could also just do a Web search and enter 529 and your state.
A: Yes. Most people use the Web site. There are also phone numbers you can call. You can call your state treasury department, and they will point you in the right direction.
Q: Can you comment on how you'd evaluate these investments differently from a plain old mutual fund? I guess when you talk about the short period of performance numbers out there, that's an issue that will make it tougher.
A: You look at several issues. Are the bells and whistles ones that work for you? Different states and different plans have different contribution limits, and they have different little bells and whistles that might differ. That's one issue.
It's hard to look at a two-year track record and pick your money managers. You have to look at the reputation of the money manager. Are you comparing the state treasury department to MFS? If I were to compare, I'd probably feel much more comfortable with MFS Funds managing my money. Are you comparing TIAA CREF against Alliance? Again, it's the reputation of the money managers.
Also, what other deductions do you have? A state like New York gives you a state tax deduction for the money on the way in on the first $10,000. That's an attractive benefit.
One very important issue is that only certain state
529 plans allow for rollovers of existing custodial accounts, the accounts set up under the old tax law. So that is also
something you'd want to look at.
Those are the sorts of things that you look at when you make your choices. What should not come into consideration is where you think the child is going to go to school or where you think you are going to reside at the time. That's more a non-issue.
Q: Finally, can you mention a couple of plans that you generally have liked for different clients, and why?
A: I like the New York plan because of the state tax deduction
for residents of the state.
Q: You mentioned that you put clients into the New York State plan up to the $10,000 contribution and then put additional money in some other state's plan.
A: I've had a lot of success with the Rhode Island plan, managed by Alliance. Now Alliance owns Sanford Bernstein; they've merged. So you have Sanford Bernstein, a world-renowned value money manager, and you have Alliance, with money management expertise in the growth area. You have an excellent growth manager and an excellent value manager all in one program. I do think administratively it's perhaps the best plan out there to work with. Another point on the Rhode Island plan is that I believe that plan has more money in it than any other plan. Americans are sort of mulling this over and making choices, and they've picked the Rhode Island plan more than any other plan.
I also like the Alaska plan. It's a multimanaged plan. They have four or five different fund managers and a wide variety of investment selections.
Plan choices include funds from AIM, Davis, Franklin Templeton, MFS, Oppenheimer, PIMCO, and T. Rowe Price. You really have diversity of money managers, and you have various funds to choose from, almost like a 401(k) line-up.
The New Hampshire plan is another one -- they use Fidelity. I would say those are the plans that are most often chosen.
Q: Are there plans that offer both a low-cost index and good money managers?
A: Alaska, using MFS and T. Rowe Price, does allow for indexing.
And that's how I manage money. I try to use a combination of active and passive investing.