Monday, February 28, 2005

Caveat Emptor: Assessing 529 Plans

Most if not all of my clients are concerned with two things--saving for their kid's college education and planning for their own retirement. Today, we'll zero in on the former, since conservative estimates put four years at a public university in 15 years at about $100,000 or more. If there is one query I receive at least twice a week, it is about 529 plans, today's biggest buzzword among parents duly worried about the overwhemingly increasing costs of a good college education.

A 529 plan allows for the prepayment of qualified higher education expenses at eligible educational institutions.
The prepayment may be in the form of a contribution to an account established specifically for paying higher educational expenses (qualified education costs include tuition, books, room, board, transportation, and even computers). There is no income restriction for individuals who want to contribute to a 529 plan; however, because contributions cannot exceed the amount that sufficiently covers the expenses of the beneficiary's qualified higher education, individuals should take care not to over-fund the 529 plan.
With the recent passing of the Economic Growth and Tax Relief Reconciliation Act, the 529 plans (named after section 529 of the Internal Revenue Code) gained their current cachet, flexibility, and tax advantages. 529 plans are essentially designed to give tax advantages to the ultra wealthy. Distributions from 529 plans for qualified higher education expenses at a qualified institution are exempt from income tax. It is these income tax advantages have contributed greatly to their popularity as a college savings vehicle. Some regular "selling points" of them include:
1.Low initial investment amounts. You can start with as little as $25.

2. Low fees. Your only expense is a management fee of 0.58%

3. Federal income tax advantages. Your assets grow tax-deferred and earnings on your withdrawals are exempt from federal income tax.

4. For New York State taxpayers, withdrawals are exempt from New York State income tax...New York taxpayers can also deduct up to $5,000 of contributions on their state income tax return each year.

5. Most state plans are also beginning to offer several age-based portfolios of mutual funds that include sundry asset allocations. These types of investment choices start out in stocks when your child is very young and shift gradually to bonds and money-market funds as your child gets closer to college-age. The idea behind the age-based portfolios is to be aggressive when you have more time, but to keep your investment safer as it gets closer to the time that you need to cash out. The perk behind this scheme is that you don't have to remember to shift the investments yourself. You can buy it and then forget about it. Self-rotating portfolios? I like the sound of that. Most states are signing on with successful investment companies such as Vanguard and Fidelity. The number and types of investment options vary by state, and once you select your option you can't change it. You can, however, roll your money over into another state's plan if you're not happy with your chosen investment option. There is no penalty to roll the money over into another state's plan, and you can do it once every 12 months. Ok, that sounds good.

6. Contributions to 529 plans also qualify for the $11,000 ($22,000 for married couples in 2002) annual gift tax exclusion, a splendid benefit in situations where inheritance money enters the picture.

Sounds too good to be true? Yep. First, think about contribution limits. You can contribute on behalf of a beneficiary until the total balance of all accounts held reaches an aggregate maximum balance which is currently $235,000. Secondly, if the child doesn't want to go to college, you can roll the account over to another family member. Ultimately, this next beneficiary has until the age of 30 to utilize these saved monies. Say all your kids get scholarships, or your next beneficiary doesn't even go to college--you're screwed. Which brings us to taxation. While, yes, the account's earnings are exempt from federal tax when they are withdrawn, that is ONLY IF the monies are used for qualified education expenses. There is also a restriction as far as your investments are concerned--since the 529 plan is a state-sponsored investment program, the state sets up the plan with an asset management company of its choice.

One major problem I have with 529s: If your child applies for financial aid, the 529 account may affect eligibility.
the 529 account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution towards your child's college costs will include 5.6 percent, or less, of the value of your 529 account for each academic year. This is actually much better than the 35 percent assessment against money that is in your child's name or in a custodial account. The only real drawback comes in when calculating eligibility the second year. At this point, 50 percent of the money that was withdrawn from the 529 account the first year shows up on your child's tax return. This decreases your child's eligibility for the next year by 50 percent of that amount.
One way to bypass this is to make sure you NEVER place the 529 account under your child's name.

Other 529 pains: The money in your 529 plan can't be used as collateral for a loan. You don't control the investments (more about how the money is invested in the next section). Your only option for changing the investments made with your money is to roll the account over to another state's plan. You can do this once a year with no penalty. If you have to withdraw the money for some reason other than to pay for qualified higher education, then you pay tax (at your rate) and a 10 percent penalty. You can only make cash contributions to the account; stocks can't be rolled over into it.

While we're on the topic of rollovers--if you're getting a state tax break by using your own state's 529 plan then you'll lose that by moving to another state's plan. Recall, however, that you can always keep the account in your state and open a second account in another state. There is no limit to the number of accounts you can have.

Parents, please make sure you look at the fees the plan charges. Some states charge an enrollment fee to open the account, and some also charge annual maintenance fees. Then there is the expense ratio, which is the percentage of fund assets that pays for operating expenses and management fees. This includes 12b-1 fees (basically, fund marketing fees), administrative fees, and all of the other asset-based costs that the fund incurs, with the exception of brokerage costs. Expense ratios for 529 plans vary from a low of 0.31 percent to a high of 2.24 percent. Additional costs can also be incurred with plans that are sold by brokers. The commissions currently range from about 3.25 percent to 5 percent. I've had to pull many clients away from these plans simply because the fees would eat up the little money they were planning to throw into the 529. Simply stated, 529s work better--a lot better--when you're overfunding them.

I suggest you find out how easy it is to get your money in the event of an emergency. Sometimes, there are time requirements about how long the money has to stay in the account before it can be withdrawn. Find out what happens with the ownership of the account if the account owner dies. Does it go directly to the beneficiary? For the same reasons named above, that could draw the unwanted attention of the financial aid committee.

Finally, let it be known that the same tax breaks which have made 529 plans so popular are themselves in limbo. Did you know that the tax exemption on 529 account earnings is in effect until 2011, which is when it can revert to the original plan where the earnings are taxed at the child's rate. Congress will have the final word--this possible reversal could affect you if your children will be going to college after 2011.

All this reminds me of Coverdell Education Savings Accounts, themselves rife with a mix of pros and cons. ESAs were improved significantly in 2002 because Congress increased the annual contribution limit from $500 to $2,000. Like 529 plans, ESA earnings are tax-free when used for education expenses, and they are considered the parents' asset so they don't adversely affect financial aid eligibility. Furthermore, unlike custodial accounts, the beneficiary does not gain control of the money at a specific age-daddy always has control of the money. This helps lessen that parental anxiety that the little tike will take the money splurge on the newest sports car. They do have some advantages over 529 plans, including more control over your investments. Their disadvantages are the limitations on parents' income. For single tax payers, the eligibility phases out for incomes between $95,000 and $110,000. For married taxpayers filing jointly, eligibility phases out between $190,000 and $220,000. Another disadvantage is that the funds have to be used for education by the time the beneficiary turns 30. Like the 529, there is a 10-percent penalty if the money is used for anything other than educational expenses.

Moral of the story, as with ANY financial decision, use caution, do your due diligence, and work with a professional.

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