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College-saving plans need a little tinkering

Updated: May 3, 2013 12:14PM

Tax-free-for-college 529 plans now have $60 billion invested in them -- a clear sign that the proper savings incentives do work. The 529 plans allow money to grow tax-free to be used for college expenses at any school, in any state, for any child in the family.

The recent federal Deficit Reduction Act helped by making it clear these investments are not to be considered assets of the student, which count heavily against the family in the financial aid process. But there are ongoing uncertainties around 529 plans that have slowed the flow of money into these valuable savings alternatives.

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.

First, parents need to understand how the two types of 529 plans work, and then the political issues involved.

Buy tomorrow's tuition today

Prepaid tuition 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.

Savings investment plans are a type of 529 plan where the growth in money to pay for college depends on the investments made in funds offered within the plan. Typically investors have 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, becoming more conservative as the child gets closer to needing the money for college.

The legislation for 529 Plans allowed each state to create its own plans, which are typically housed under the state treasurer's control. The designated fund-management companies share fees with the state, based on the amount of assets in the plan. Thus, states have an incentive to grow their plans by offering state income tax breaks on investments and withdrawals.

Each state also sets its own fee and commission structure. Accounts may be opened without commissions if 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 is that brokers and planners provide a valuable service in encouraging these investments. In fact, about 80 percent 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 describe the tax incentives by comparing all 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 comparisons.

One excellent Web site,, does allow savers to compare plan features. But only Morningstar is attempting to compare performance and costs.

In its latest Morningstar FundInvestor Newsletter, analyst Kerry O'Boyle rates the Alaska plan, run by T. Rowe Price, and the Utah plan, with investments in Vanguard funds, as the tops in being both low-cost and having "sound asset allocation" strategies. Illinois' returns are middle of the pack, but state tax benefits provide powerful incentives to invest in Bright Start and College Illinois, the prepaid college tuition plan.

Parental demands

So what should concerned parents be demanding now? College 529 plans were created with the right structure and the right incentives. Here's what will help make the concept even more useful: long-term extension of 529 legislation, standardization of age-based plans, annual required (after-cost) results reporting, equal state tax incentives no matter which plan is used.

If states offer the same tax treatment to any citizen who invests in any 529 plan, and if plans can easily be compared based on performance, and if we're sure the plans will be around for many years to come, we'll have all the right incentives to reach the very important goal of educating our children. That's the Savage Truth

Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.

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