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The pros and cons of 529s
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October 15, 2001: 11:17 a.m. ET
College savings plans aren’t perfect, but new tax rules move them to the head of their class.
By Sarah Max
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NEW YORK (CNNmoney) - Soon to be tax-free 529 plans have fast become the savings tool of choice for college tuition. Yet some financial planners continue to steer clients away from them because, they say, the plans jeopardize financial aid, lack flexibility and aren't always tax-free.
"Everybody's putting money in these things and not thinking about all the strings that are attached," said Rick Darvis, a certified public account who specializes in college funding.
While you don't want the tax windfall to blind you to the potential drawbacks of 529 plans (and there are some), many of the complaints associated with these investments will be irrelevant when the 2001 Tax Relief Act takes effect at the start of next year.
Old complaint: The tax benefits ain't so great
Until recently, some financial planners argued they could whip up 529-like tax savings with tax-efficient funds or by putting money in the child's name where it is taxed at a lower rate. Though earnings in 529 plans are not subject to annual capital gains taxes, they are - at least until January 2002 - taxed at the student's rate when funds are withdrawn.
Come 2002, however, all 529 money used for higher education will be exempt from federal income tax, and in many cases state tax. Even the most skilled planner will have a tough time crafting that kind of protection.
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Families that can save for college are so much better positioned than those who choose not to save for the sake of financial aid.
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Jack Joyce
Director of guidance services for the College Board |
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"On the tax front we pretty much got all the we could hope for," said Timothy Lane, vice president of tuition financing for TIAA-CREF. "The only way to make it better is to make it deductible, and in certain states it is."
As an added perk, the existence of a 529 plan will no longer preclude opening an Education IRA or claiming the Hope or Lifetime Learning credits. Credits can even be claimed the same year that 529 savings are withdrawn as long as the money is put toward different expenses.
Old complaint: 529s jeopardize financial aid
Financial planners have long warned that 529 plans kill any chance of securing financial aid because withdrawals are reported as the student's income. (Students are expected to put 50 percent of their income toward tuition, but only expected to put about 35 percent of their savings toward school.)
Though no guidance has been issued on how financial aid officers will treat 529 plans now that there is no income to claim, it's likely 529 assets will be treated like any other parental asset.
"I don't know how this is being discussed at the federal level, but the word in the financial aid community is that 529s will be recorded as the parent's assets and assessed the same way as any other asset," said Jack Joyce, director of guidance services for the College Board.
Brian Orol, a financial planner in North Carolina who also thinks 529s will count as parental assets, notes it will be virtually impossible for financial aid offices to track 529 withdrawals once the IRS stops charging taxes on them.
Click here for CNNMoney's 529 search tool
But even under the current treatment, the benefits of 529s far outweigh any potential impact on financial aid, Joyce said. "Families that can save for college are so much better positioned than those who choose not to save for the sake of financial aid," he said.
In the worst case scenario, assuming nothing changes with 529s and loan assessment calcuations, there is a way to sidestep the potential impact on financial aid: Allocate most of your 529 savings to the beneficiary's junior and senior years of school.
Old Complaint: Plans lack flexibility and disclosure
One other gripe among the financial planning community and investors has been the lack of flexibility that 529 plans provide. Previously, if families wanted to shift their assets to another state or into different investment options, they had to do some precarious juggling.
Beginning in January, however, 529 savers can roll their account to a different plan once every 12 months. As of September 2001, plan participants also can reallocate their funds to different investment categories once a year as well.
While these new rules have cut some of the strings attached to 529 plans, critics say disclosure remains an issue. "Disclosure is going to have to get better," says College Money's Raymond Loewe. Unlike mutual funds, 529 plans are not required to share their performance with investors on a regular basis.
At the same time, some critics contend the lack of disclosure allows state-sponsored college savings plans to charge higher than average fees for managing their accounts - anywhere from 1 percent to 2 percent of annual earnings.
That said, growing competition in the 529 market is pushing many states and investment firms toward greater disclosure. In fact, many of the companies running these plans post daily performance stats on their Web sites. "These big fund companies managing them are providing the same level of disclosure as the mutual funds," said Joe Hurley, a CPA and 529 expert.
The potential for penalties
Here's one complaint that hasn't changed: If your only child decides he'd rather join the circus than go to Harvard you will pay a penalty for not spending your 529 savings on education. In fact, if you take a non-qualified withdrawal, you pay ordinary income tax on your earnings (taxed at your rate, not your kid's) and a 10 percent federal penalty tax. In some cases, you'll pay a 10 percent state tax on your earnings as well.
Joe Hurley, however, says this should not be a deterrent. "You get 100 percent of your principal back, and the value of tax deferral is often greater than that 10 percent penalty on earnings," he said.
Loewe recommends families try to estimate upcoming college expenses and take care not to over-fund 529 plans unless the circumstances change. "The biggest question is: What is your exit strategy if something changes? That's my problem with 529 plans," he said. 
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