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Flaws showing in 529 plans for college savings

Worried about how you'll send your kids off to college? You're not alone. According to a recent survey, 44 percent of parents say they are not prepared to pay for their children's college education, though 65 percent fully expect their kids to attend.

Even scarier: 16 percent of parents plan to dip into their retirement funds to help out their kids, and another 7 percent plan to finance at least a portion of education with credit cards. Eeesh.

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We have the perfect savings tool for college funding available to us -- 529 plans, those state-sponsored savings programs that allow you to sock away thousands of dollars a year in a tax-deferred account for your kid's (or grandkid's) higher education.

Well, OK, they're not quite perfect. Some might call them seriously flawed. In recent months, 529 plans have been under severe scrutiny by a task force of the Securities and Exchange Commission, both houses of Congress and the National Association of Securities Dealers. Their shortcomings came to light recently as a result.

A mini primer
There are two types of 529 plans -- the tuition prepayment plans, where you pay ahead for tuition costs that are applicable to the public universities in your state. These more-restrictive plans came on the scene in the 1980s and are now waning in popularity as the newer 529 savings plans, introduced in 1997, take a foothold in the marketplace. So far 529 savings plans have attracted $45 billion of assets nationwide.

The pros of the savings plans: Earnings grow tax-free, and when it's time to matriculate, you can take the money out without paying federal taxes, as long as the money is used for qualified education purposes.

On top of that, the earnings may be free of state taxes, and you may also get handsome state income tax deductions for contributions made along the way.

Each state has at least one type of 529 plan, some have both types, and a few even offer several different versions of the savings plans.

Drawbacks of 529 savings plans
They are not regulated under federal securities laws, so they lack the transparency of other securities. As a result, disclosure about all the various fees involved with these plans has been inconsistent and spotty at best, making it all but impossible for people to make apples-to-apples comparisons between plans.

Some states offer 529 plans with fees that are indefensibly high. That in itself may not be so alarming. Just as there are good mutual funds and bad funds, there are good 529 plans and bad plans. But so far folks do not seem to be able to discern between the two, because they're being herded into high-cost plans that have little tax benefit.

Two accounting professors at the University of North Carolina at Wilmington studied 77 different 529 savings plans over two years, and found that the plans with the highest fees tend to have a disproportionate share of investors as well as assets. At the same time, they discovered that the 529 plans in states offering handsome tax deductions have fewer investors.

"Investors are choosing out-of-state plans with higher fees and forgoing significant state tax benefits," the professors reported in their study. "We find no support for the theory that investors choose plans based on low fees and state tax subsidies."

It's not that people are stupid. It's that advisers are steering their clients into 529 plans that pay good commissions, even though the plans may be completely inappropriate for their clients.

Separately, the National Association of Securities Dealers has been conducting its own investigation of more than a dozen broker-dealer firms that have sold 529 plans to investors.

In a hearing before the U.S. Senate Committee on Government Affairs last fall, Mary L. Schapiro, NASD vice chairman in charge of regulatory policy and oversight, shared this shocking finding:

"We were troubled to discover that more than 90 percent of the sales by some firms were to out-of-state residents, despite the fact that about half of the states give a state tax deduction to their citizens for contributions to the home state's 529 plan." In fact, she continued, "Regardless of the number of 529 plans sold, the vast majority of sales were made to residents outside of the state that sponsored the 529 plan."

This is seriously disturbing, because people who invest in a different state's plan could get taxed or hit with a fee when they begin withdrawing money from the plan, either by the outside state or their own state -- possibly both. Naturally, investors in plans outside their home state don't get their own state's tax breaks either.

On the other side of the issue, critics say the states have designed protectionist policies in an effort to keep their residents in their home-state's plan. The states serve as interloping middlemen, they argue, who often charge high fees that negate any tax breaks.

Fee disclosures may improve
In December, the National Association of State Treasurers and its affiliate, the College Savings Plans Network, released disclosure guidelines that the 529 savings plans are expected to embrace. If they are widely adopted, people will be able to more easily compare the various state plans and make intelligent decisions -- with or without a broker's "help."

The guidelines suggest that the following costs be broken out:

  • estimated underlying fund expenses
  • program manager fee
  • state fee
  • miscellaneous fees
  • annual distribution fee
  • total annual asset-based fees
  • maximum front-end or back-end sales charges
  • annual account maintenance fee

Not all of these costs apply to every plan. Those that are direct-sold, for example, won't have front- or back-end loads. Right now, it's relatively easy to research some, though not all, of these expenses on Web sites such as or Morningstar's college savings investing center. Currently, prospective investors may or may not see a complete breakdown of fees in a particular plan's program documents, since some plans only provide a general expense ratio rather than an itemization of costs.

Don't kid yourself. The states have come up with these long overdue guidelines less out of a sense of duty to the public and more to protect their territory. 529 plans were their creation, after all. But the guidelines are an attempt by the states to stave off interference by federal regulators and show that the states are quite capable of policing themselves. Too bad they didn't come up with this sooner.

Plus: 4 keys to choosing a 529 plan

Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning.

-- Updated: Oct. 16, 2006




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