Learning Aids

With all the media hype over 529 plans, it would seem the tax-advantaged college savings vehicles would be roaring across the radar screen of every education saver and advisor in the nation. One planner heralded the advent of 529s, the Darwinian offshoot of state prepaid tuition plans and named after the tax-code section that sanctioned them in 1996, as the greatest thing since sliced bread. The answer to why so few college savers are using them may be that the loaf hasn’t quite come out of the oven. What happens when it does remains to be seen.

Cerulli Associates, a Boston-based research and consulting firm–whose data can be found in our 529 directory beginning on page 57–noted in July that only 3.9% of U.S. families that include children under 18 have a 529 plan. But according to a Cerulli report published in November 2001 entitled “The State of The College Savings Market: 529 Plans in Perspective,” that figure (up from 2.4% in November) is expected to grow by more than 8% over the next five years. The average 529 account balance last year was less than $5,000 (37% of plans had less than $1,000), but that figure also is projected to rise, to just under $15,600 by 2006, according to Cerulli.

Advisors accustomed to utilizing sophisticated financial products on their clients’ behalf may find surprising a study conducted in May by Harris Interactive for AEGON Institutional Markets. (The latter company, a Louisville, Kentucky-based unit of AEGON Insurance Group, sells stable value products–insurance-based fixed income investments that maintain the value of the principal and accumulated interest–and believes stable value is a viable 529 plan component. In March, for example, Rhode Island added stable value to its investment mix.) AEGON’s study of parents with children under 18 years of age shows that bank savings accounts remain the most popular college savings vehicle. Sixty-one percent of parents use savings accounts, up 7% over 2001. Mutual funds and savings bonds are used by 44% and 37% of survey respondents respectively, according to the study.

Still, word about 529 savings plans is spreading fast: more than 40 financial services companies, many armed with mammoth marketing budgets, manage or distribute 529s. Cerulli notes in its 2001 report that as parents seek out information about new college savings vehicles, financial planners and advisors are discovering that they must “be prepared not only to offer advice about mutual funds, annuities and retirement, but also about college savings, which is quickly becoming a fourth and crucial component of every financial services providers’ product lineup.” Jeff Bogue of Bogue Asset Management in Wells, Maine, believes that many advisors are not up to speed on 529s because the plans are in constant flux. The state may at any time alter plan provisions or switch program managers, he explains. Matthew Olver, a planner with Spero-Smith Investment Advisors in Cleveland, believes that advisors, let alone the public, are still “getting comfortable” with 529s. “They’re a very different investment vehicle than anything else that has existed,” he says. “It’s not easy to fully understand exactly how they work.”

Heads Up

The Byzantine aspect of 529s is good news for plan-savvy advisors who stay ahead of the curve and for the growing legions of college savers who should depend upon them. The AEGON study indicates that the number of parents who have read or heard of 529 plans doubled between 2001 and 2002. Utilization of 529s has been slow for a number of reasons, not the least of which is that it’s hard for many Americans to save for college when pressured with myriad other financial concerns, especially retirement. As for 529s, they only came into vogue about four years ago (though the IRS added section 529 to the tax code in 1996). Before achieving tax-free status last year as part of EGTRRA, growth in the accounts was tax deferred, which necessitated saving money in order to cover taxes when taking money from the 529 plan–reason enough for many advisors not to recommend them. Also, each 529 state plan is composed differently, and none is particularly easy to understand. “All of the ‘noise’ on 529 plans makes them seem overly complicated for many parents, and they don’t have the time to research them on their own,” says Phil Dyer, senior manager at Wealth Management Services in Towson, Maryland. And as Bogue says, 529 plans are “kind of murky. You’ve got to figure out all the tax scenarios, the operational rules, funding minimums, and review at least 16 different investment choices–and choose a state.”

All 50 states, and the District of Columbia, are expected to have at least one 529 plan by the end of 2002. Data from Cerulli’s 2001 report on 529 plans show concentration of 529 assets to be in the 10 largest state plans: Ohio, New York (whose plan topped over $1 billion in assets as of year-end 2001), New Hampshire, Maine, Massachusetts, Rhode Island (the largest plan, with more than $2 billion in assets as of year-end 2001), Pennsylvania, California, Illinois, and Connecticut. Initial minimum and subsequent plan contributions vary from state to state (Nebraska is the only state with no minimum requirement), ranging from a low of $10 in Louisiana to a high of $1,000 in Massachusetts and New Hampshire. Some states impose higher initial minimums for out-of-state investors; Kansas and Arkansas require non-state residents to post $1,000 as an initial contribution, while in-state residents may open an account with $500 and $250, respectively. Cerulli notes that New Jersey requires subsequent contributions of $300 annually until the account reaches $1,200, at which point there are no minimums. Subsequent minimum contributions range from $15 in Colorado to $100 in New Mexico.

Aided significantly by the tax-free withdrawal status it received in 2001 (under prior law, 529 plan withdrawals were taxed at the child’s tax rate), 529 plans have become the nation’s preferred college savings vehicle, topping prepaid plans and Coverdell education savings accounts, formerly known as Education IRAs. Cerulli projects that assets in 529 savings plans nationwide will exceed $51 billion by 2006, growing at an annual rate of 48%.

Also-Rans

As for the viability of the other savings vehicles, there isn’t much, at least according to John Stelman of Stelman & Associates in Lake Orion, Michigan, who for years has closely followed college funding. He finds the original Education IRA, with its $500 maximum yearly contribution, “a joke.” He considers the Coverdell version, with the contribution limit per beneficiary bumped up in 2002 to $2,000, thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, “a little less of a joke.” Louis Kokernak of Haven Financial Advisors in Austin, Texas, characterizes the Coverdell IRA as effectively being a nationwide “voucher” for parents who want to provide their children’s secondary or college education, adding that tax-free withdrawals for the Coverdell “extend to virtually all facets of the educational experience.”

The Coverdell does have its virtues, however. Suzzette Rutherford of Rutherford Asset Planning in Naples, Florida, likes it because of its secondary-education use, and because management of assets is fully under the control of the plan contributor. Like a 529, she adds, the monies in the Coverdell grow tax-free and qualified withdrawals for education are tax-free as well. She recommends the Coverdell to college savers who have only $3,000 or less to contribute each year.

Stelman believes that state prepaid plans, which provide a hedge against inflation (and which by last year had amassed total assets of about $14 billion, according to Cerulli) and a guarantee that savings will meet future education costs, offer too little flexibility, and will soon be extinct. “Since 1987, when the first prepaid came out in Michigan, 1,500 to 1,700 contracts a year have been going out,” he says, “which is a dismal failure.” Prepaids generally cover only state-funded public universities. How, Stelman questions, does a family and child who begin saving for college a decade before college freshman year, know with certainty that the child will still want to attend a state school when it’s time to apply? If the child decides instead to go to a private college or university, or not to continue his education at all, the parents will “lose a chunk of money,” says Stelman. He believes that sooner or later “somebody” will put a 529 savings plan together that offers, as a component, the prepaid-plan guarantee to pace inflation.

Hope or Hype?

Regarding college savings in general, KC Dempster, director of program development for College Money, a college counseling firm in Marlton, New Jersey, maintains that for the most part, “anything that helps to save money is good.” (See book review sidebar on page 54.) Parents today believe they must save $80,400 on average for one child’s college tuition, an increase of nearly $35,000 from what they held to be true in 2001, according to the AEGON study. Cerulli points out that families saving for a baby born in 2001 will need to accumulate nearly $250,000 to cover the total cost of sending their child to a four-year private college. Parents also are less optimistic about potential returns on their investments than they were last year, and are extremely risk averse, according to AEGON. Lynn Allen, AEGON’s director of public markets, says that “with the events of the past year and continued uncertainty about the stock market, parents are worried.” Their expectations regarding potential returns, while lower than in 2001, continue to be somewhat unrealistic; the AEGON study, conducted in March, found that on average, parents expect 19%, down from 24% in 2001. The survey found that only 10% reported an actual return of 10% or more–with significantly more parents reporting a return between 1% and 9%–compared to 18% in 2001. Boosting the parental apprehension level is the knowledge that the college tuition inflation rate, at around 7.5%, is double that of the overall inflation rate, according to College Money.

That said, are 529s the answer to parents’ college saving needs? A review of 529 attributes shows that these plans can be used for college expenses in any state (while prepaid tuition plans are designed for in-state use); and that parents (or whoever contributes) maintain control over the money in 529s, while custodial UGMAs (Uniform Gifts to Minors Act) release control of funds to students when they reach the age of majority–allowing them to jet off to Bali instead of Princeton. The allowable one-time gift of up to $50,000 into 529s provides enticing estate tax benefits (the gift can be taken back, though the donor must pay a 10% penalty to the federal government). This is especially advantageous for grandparents who wish to remove cash from their estates.

Other 529 benefits: the contributor can be virtually anybody; there are no limits placed on parent income; and adults can actually contribute to their own 529 plans if, for example, they wish to attend medical school. As noted above, withdrawals from 529 plans are tax-free (as long as the monies are used for education costs). And assets in 529s, unlike those in UGMAs, are not considered student assets in the formulas used to determine financial aid, though they were prior to the EGTRRA 2001 legislation. There’s a not-so-obvious catch regarding this benefit, which we’ll examine later.

“The 529 is a panacea,” says Stelman. “It meets all the criteria that anybody could have in terms of meeting needs in a college funding vehicle.” College Money’s Dempster notes that “To be able to save money for college and use it tax free for college is outstanding, because the compounding is phenomenal.” Dennis De Stefano of De Stefano Wealth Management in Maui, Hawaii, finds 529 plans to be “college savings, retirement planning, and a tax shelter rolled into one.” Doug Pauley, of Pauley Financial Services, Inc., in Pound Rock, Texas, says that “Section 529 plans are the perfect college-funding vehicles for grandparents,” though he isn’t a fan of 529s for parents unless they have fully funded their retirement and long-term care needs. “They have tremendous planning opportunities that are possibly broader than just saving for education,” says Jeffrey Mehler, an advisor in Centerbrook, Connecticut.

What’s Not to Like?

Even 529s’ staunchest supporters agree the plans are not for everyone. And some advisors are downright wary of 529s, feeling that the media-fueled enthusiasm they engender may make some college savers blind to the plans’ disadvantages.

Haven Financial’s Louis Kokernak is concerned that the plans are being oversold as an estate planning tool when inherently, he says, the disposition of assets from the plan is restricted for education use only. Jim Garvey of Northstar Financial Planning in Hudson, New Hampshire, doesn’t use 529s for estate planning at present, suspecting that the rules may be soon modified to eliminate the usefulness of the plan as an estate planning vehicle.