Magazine

Time to Rethink the 529


The tax-free status of state-sponsored college savings plans -- known as 529 plans, after the part of the tax code that created them -- once made them the best deal around. But because of recent tax cuts, other approaches are now almost as attractive from a tax angle. Moreover, since many 529 plans charge high fees, it's possible to come out ahead with a taxable investment -- as long as it has rock-bottom costs. The lesson: A 529 is not the no-brainer it was just a few months ago.

The 529's tax advantages can still make it a winning strategy. You'll pay no taxes on your investment gains unless you tap the account for something aside from higher education. Better still, half the states allow investors to deduct at least a portion of their 529 contributions from state income taxes.

If your home state's 529 plan offers a generous deduction, think twice before pursuing a different option. Consider the Missouri Saving for Tuition Program. It gives couples a state-tax deduction for up to $16,000 in annual contributions. For a family in the state's top tax bracket of 6%, that works out to a savings of $120 a year on a $2,000 annual investment, says Jennifer Ma, a research fellow at the TIAA-CREF Institute, the research arm of TIAA-CREF. CREF runs 529 programs for 13 states, including Missouri (although come November, it will no longer run New York's plan). That's more than enough to offset the slightly higher fees you'll pay in Missouri's plan, which charges 0.65% -- or $13 a year for a $2,000 investment -- vs. $3.60 for the same contribution to a low-cost index fund that charges just 0.18%.

In the absence of a tax deduction, however, the 529's fees can erase its tax advantage. That's because 529s often levy several layers of fees. Typically, these include expense ratios on the plan's mutual funds, as well as a program management fee to cover administrative costs. In addition, some plans charge enrollment and account-maintenance fees. And if you sign up through a broker -- as a growing number of people do -- you could pay a sales charge of as much as 5.75% of your contribution, says Joseph Hurley, founder of Savingforcollege.com, which compares 529 plans.

To see how this can add up, look at Wyoming's College Achievement Plan. It charges between 0.67% and 1.77% a year for the individual funds it offers, plus a program management fee of 0.95%. Out-of-state residents with balances below $25,000 pay a $25 annual account-maintenance fee. As a result, some investors fork over more than 2.7% of their account's assets each year to cover these costs. That's a serious drag in an era of low investment returns.

MIND THE FEES

If your state's plan offers no deduction to offset its fees, you may do better with another type of tax-advantaged college investment account -- a Coverdell Education Savings Account. It works like a 529 in that you can withdraw money for college tax-free. The trick with a Coverdell is to qualify: Only single taxpayers earning less than $95,000 and married couples making less than $190,000 are eligible to fully fund them. And there's a cap of $2,000 on annual contributions.

Then there's the long-standing custodial account. With these, only the first $750 of earnings is tax-free. But if your child is 14 or older, the tax hit from a custodial account is likely to be small. That's because taxes on investment income of more than $750 are computed at your child's rates. If you can invest the money in a way that it earns only dividends and long-term capital gains, you'll pay Uncle Sam just 5% -- assuming your child's taxable income is below the $28,400 threshold for the bottom two tax brackets. Under the old tax laws, you would have paid as much as 15%. (One caveat: If your child is under 14, any earnings beyond $1,500 a year will be taxed at your rate.)

The fees on a Coverdell or custodial account can be quite low. That's because the only fees you should pay are the expense ratios on your funds. Put the Vanguard 500 Index fund into your Coverdell or custodial account, for example, and you'll pay an annual expense ratio of just 0.18%. In contrast, a stock fund costs about 0.80% in California's 529 plan.

Fees can make a big difference when it comes to returns. Consider an investor in the 28% tax bracket who contributes $2,000 a year to an equity fund in a 529 plan that costs 1% a year and offers no state tax deduction. If the fund earns 6% a year, the investor will have nearly $59,000 available for college 18 years later, according to TIAA-CREF. But the investor could have about $4,500 more with a custodial account, and about $5,400 more with a Coverdell account. The reason? The 529 costs 1% a year. But with a Coverdell and custodial account, you'll pay just 0.18% if you invest in a low-cost Standard & Poor's 500-stock index fund.

The 529 approach can also lag behind when it comes to age-based portfolios. These investment programs automatically shift from stocks to bonds as a child approaches college age. In the case of a $2,000 annual contribution that earns 6% on its stock and bond investments and 4% on its money-market funds each year, the 529 plan accrues nearly $58,000 after 18 years, compared with just over $63,000 for a Coverdell and $61,400 for a custodial account.

Again, higher fees set the 529 back. Instead of paying 1% for an age-based portfolio in the 529, an investor can replicate these same allocations in a custodial or Coverdell account for as little as 0.18% for a stock fund, 0.22% for a bond fund, and 0.33% for a money market fund. (If your college savings strategy is heavily weighted towards bonds from the outset, it makes sense to shield the taxable income they generate in a 529 or Coverdell, instead of a custodial account.)

WHO HOLDS THE PURSE STRINGS?

There are trade-offs to investing in these other accounts. With a custodial account, the money becomes your child's to control at 18 or 21: The exact age depends on your state's laws. As a result, you have to be confident your child won't skip college and blow the money on other things. Also, keep in mind that the more you plan to contribute each year, the greater your custodial account's potential gains -- and tax bill.

Finally, although it's hard to predict future financial needs, those who anticipate applying for financial aid may be better off with a low-cost 529 plan. That's because the federal government's financial-aid formula considers only up to 5.6% of the balance on a 529 owned by a parent available to pay for college. In contrast, 35% of the dollars in custodial and Coverdell accounts are counted towards the family's college contribution.

To complicate matters further, today's tax rates may not remain in effect for the long term. The tax-rate reductions that have given custodial accounts a new lease on life are due to expire on Jan. 1, 2009. Meanwhile, 529s are scheduled to lose their tax-exempt status in 2011. Congress may act to block the tax hikes. But regardless of what happens to the tax code, the lesson is clear: It's not only tax advantages that matter; fees do, too. By Anne Tergesen


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