Fidelity Outlook Magazine

How to choose a 529 plan

For parents considering investing in a 529 college savings plan, the choices have never been greater – and the process of picking the right one more confusing.

Not that you can really go wrong with any of these tax-advantaged mutual fund portfolios. Named after the section of the tax code that governs them, 529s are an investment tool whose time has definitively come. Last year at this time, 35 states offered 529 plans; today, it’s a clean sweep, with all 50 states either currently offering or developing a plan, most of which are available to residents of any state. “People talk about this as the 401(k) of college savings,” says Eric Nottonson, Fidelity vice president of college planning. “It’s the first broadly accepted way to save for college.”

One reason for the attraction of 529s is that the alternatives had been frustratingly meager. Parents can plunk only $2,000 a year into a Coverdell Education Savings Account (formerly an Education IRA); even with regular deposits and compounded interest, the final sum barely dents five-figure tuition bills. A custodial account? The parents’ tax savings are minimal and you give up control of the assets to your child when she reaches her majority. Prepaid tuition programs limit your child’s choice of schools. “The bang for your buck wasn’t there,” comments Dave Springsteen, a CPA with New Jersey accounting firm WithumSmith+Brown.

With 529 plans, however, anyone, regardless of income, can open an account for a family member and contribute up to $11,000 a year ($22,000 per household) to designated stock and bond mutual funds. Most plans let you invest as little as $25 a month – or as much as $55,000 ($110,000 per household) in a lump sum during a five-year period. The money can be used at any accredited school in the country, and the account-holder doesn’t loosen the purse strings until the beneficiary presents the first tuition bill.

The original interest in 529s was fueled by the fact that taxes on the account were deferred until the money was withdrawn. But the program’s popularity has since been turbocharged by two recent regulations. The Economic Growth and Tax Relief Reconciliation Act of 2001 made withdrawals free of federal tax. (Although the act only applies through 2010, most financial experts are betting that the so-called sunset provision will be revoked.) Many states immediately followed suit, as well as offering additional tax breaks for residents.

Then the Internal Revenue Service issued a notice last year that gives plan holders more financial flexibility. Under the old rules, you locked into a particular portfolio when you designated a beneficiary; if you wanted to change your investment options, you had to change beneficiaries. Today, plan holders can switch portfolios once a year without penalty.

Rolling over a plan to a different beneficiary has also become easier. You can do it as often as you like, as long as the second beneficiary is of the same generation as the first, and fits the IRS definition of family member—brother, sister or first cousin. Otherwise, you may be subject to generation-switching gift taxes.

Jim Ferrare is particularly pleased with these developments. With college only six years away for his oldest child, the Redbank, New Jersey-based money manager is concerned that the time horizon may be too short to recover from a prolonged down market. Thanks to the leeway offered by the IRS notice, he says, “I will not be pressed to sell the portfolio at a loss. I can stick with the assets and change the beneficiary to my six-year-old if I don’t like the market conditions.”

Enough people share Ferrare’s enthusiasm that Cerulli Associates, a financial consulting firm in Boston, estimates that assets in 529 plans will grow to more than $51 billion by 2006 from more than $7 billion at the end of 2001. Financial Research Corporation, a Boston-based firm that works with the mutual fund industry, aims even higher, predicting 529 assets could grow to $400 billion by 2010.

But with 50 states often offering more than one plan, it can be difficult to determine the right one for you. (The website HYPERLINK provides an easy way to compare all the offerings.) And the stakes are high. Each state offers a different set of benefits beyond the upfront tax advantages: tax deductions, maximum contributions, investment options all differ. Like any investment vehicle, these plans have risks as well as rewards. “The choice is 95 percent of the game,” says Ren Cheng, portfolio manager of Fidelity’s 529 plans. These questions will help you focus your search and choose the right answer.

Who’s got the best tax breaks? “When comparing plans, first consider your own state’s plan, as some offer alternative tax benefits to residents,” says Nottonson. One strong incentive to sticking with your home-state’s program: In addition to the exemption from taxes on the earnings, some states allow you to deduct some or all of your contributions. In New York, for example, a parent can deduct up to $5,000 in 529 contributions ($10,000 for a married couple) off her New York State income tax each year. In Colorado, you can deduct as much as you contribute.

Other states induce residents to keep their money at home with other types of financial incentives. New Jersey automatically awards a $1,500 first-year scholarship to program participants provided they go to any accredited in-state institution.
The penalty if you invest in an out-of-state plan? Your earnings will be taxed at your home state’s rate.

Who’s minding the money? One of the toughest decisions for any investor is choosing a money manager. Most of the 529 programs have very short track records, so it’s difficult to use past performance as a gauge in determining future returns.
An increasing number of states are turning to investment companies with successful records managing retail mutual funds and pension plans, such as Vanguard, Fidelity, T. Rowe Price and TIAA-CREF, to name a few. In fact, New Jersey’s decision to have the state employee pension plan manage its college savings program queered the deal when Ferrare started investigating 529 plans. “It was not an option for me,” he says. “I’m concerned about a lack of a track record.”

Reputation even trumped the home-state tax advantages when John W. Andrews of Bloomfield Hills, Mich. set up a 529 plan for his two-year-old granddaughter. “I decided to go with management over the state tax issues,” he says, explaining why he signed up with Fidelity’s New Hampshire-based UNIQUE plan. “I thought that Fidelity will spend the time to continue researching all the aspects of this kind of program. I don’t have that capability or time or knowledge. I felt that was much more important than any tax sanction that might be involved.”

How will your money be invested? Most management firms offer two portfolio classes– static and age-based – each of which comes with a variety of investment options.

Static portfolios stick with a specific balance of equities and non-equity investments for the duration of the investment. Age-based portfolios shift the weightings according to the age of the child. The plan starts off by aggressively investing in stock mutual funds when the child is young, then moves into more conservative investments, such as bonds and money markets, as the child nears college age. If you open an age-based portfolio for your three-year-old daughter with Fidelity’s UNIQUE plan, 88% of the assets would be in equity mutual funds at the outset, but by the time your child handed you that first tuition bill, the majority of the money would be socked away in less volatile bond funds. Fidelity offers eight age-based portfolios in the plans it manages for New Hampshire, Massachusetts and Delaware, with time horizons ranging from two years to 18.

Tad and Samantha Truex of Ashland, Mass., opted for the age-based plan offered by the state of Massachusetts for their two-year-old son, newborn daughter and three nephews. “It’s an easy way and it seems safer,” says Samantha, who works for a biotech company. “Although we want to be sophisticated about how our money is invested, we don’t want to spend time each month or each quarter figuring out where our money should go.”

The hands-off aspect of the age-based investment approach also appealed to John Andrews. Now 70, he says, “I may not be here 17 years from now. If I’ve established a pattern of being involved in making decisions, what happens when I’m out of the picture?”

More active investors needn’t dismiss 529 plans as one-size-fits-all. You can mix and match portfolios, within the fund management’s family of offerings. “If you were intrigued by the idea of an age-based portfolio but wanted to make that particular portfolio more aggressive, you could put a portion of your investment in the age-based portfolio and another in the 100% equity portfolio,” says Nottonson. “Or if you like the idea of a static portfolio but didn’t see the mix you wanted, you could use a combination to achieve anything in between. If I wanted a 50/50 mix, I’d put half in the 100% equity portfolio and half in the zero equity portfolio.”

Jim Ferrare customized his 529 accounts by investing in the programs offered by two different states, with two different fund managers. As a principal with Pinnacle Asset Management, Ferrare liked the fact that Alaska’s College Savings Plan offered by T. Rowe Price diversifies among equity asset classes. “For the last few years, large-cap stocks have out-performed the market, but I want exposure to small- and mid-cap, as well as international stocks,” he says. He also chose an index fund managed by Vanguard in the Utah Educational Savings Plan Trust. “It gave me a passive index that was low-cost. There was no investment manager risk, and if the markets were going higher, I was going to participate.”

What are the management costs? Just two years ago, before the boom in 529 plans sold by national investment firms, roughly 80 percent of all assets were invested through state programs, according to Luis Fleites, an analyst with Cerulli Associates. One year later, that percentage had dropped to 55 percent, and Fleites predicts it further declining to 40 percent by the end of 2002.

While the increasing role played by financial intermediaries has resulted in more options for investors, it has also led to a wide range of expenses. “You need to be aware that these funds are not fee-free,” cautions Christine Pronek, a tax manager with WithumSmith+Brown.

Adds Joseph F. Hurley, founder of and author of The Best Way to Save for College: A complete guide to 529 plans, “It’s really important to look closely to understand how these fees operate.” Upfront enrollment fees, annual account maintenance fees (a fixed fee that’s often waived if you sign up for automatic contributions or when your account balance reaches a certain size), management fees based on the amount of the assets, and the expenses of the underlying mutual funds can combine to take a sizable bite out of your earnings, especially for out-of-state participants. For example, Rhode Island residents investing directly in their state’s CollegeBound Fund, managed by Alliance Capital, pay a ballpark expense ratio of 1.25 percent; non-residents, however, have to fork over front-end brokerage commissions of 3.25 percent and asset-management fees of 1 percent a year or more, While several companies, including Putnam Investments and Fidelity Investments, suggest on their websites that prospective customers consider the tax advantages of a rival, home-state plan, not all companies do.

When can you withdraw your money? Unlike Coverdell savings plans, which require withdrawing the money by the time the beneficiary is 30 years old, most 529 programs don’t have any time or age limitations. What they do have, however, are limitations on the total amount of contributions and/or assets, and those numbers differ according to each state’s plan. New York’s college savings program, perhaps to balance its strong tax advantages, slaps a surprisingly skimpy ceiling of $100,000 on maximum contributions to its plan. Other states slam the door when an account reaches an amount deemed a fair market value for qualified higher education expenses. The cut-off for Alaska’s College Savings Plan, for example, is $250,000 and the College Bound Fund of Rhode Island stops at 265,620.

You’d need a crystal ball to know which college your diaper-clad toddler is going to attend 15 years hence – and how much of a nest egg you will need to amass. But you can make an educated guess about the cost of a college by checking out the College Savings Calculator at HYPERLINK The calculator crunches college inflation rates and the consumer price index, applies the figure to benchmark institutions according to geographic region, type of college and your child’s freshman year, then extrapolates projected costs. For example, the estimated bill for a student entering the University of Denver, categorized as a mid-range school in the Midwest, in 2012 is $51,303; by the time she graduates, you will have had to pony up $229,133. Four years at Northwestern University, starting in 2012, will cost close to $300,000.

How do those figures affect your investment strategy? “If your objective with a retirement plan is to beat taxes and inflation, the objective with a college plan is to beat taxes and college inflation,” says Raymond Loewe, president of College Money. For the past 30 years, college inflation has averaged 7.49 percent, compared to a Consumer Price Index of 5.14 percent. When evaluating 529 offerings, Loewe counsels, “Make sure you have a large enough choice of portfolios to meet your investment objectives.”

Other considerations when choosing a plan: Many plans have a waiting period before you can withdraw funds. Most of these are relatively short – New York State’s, for example, is three years – but it’s worth keeping in mind.

More important is the reimbursement process for qualified high education expenses (QHEEs). These days, most plans agree that QHEEs cover tuition, fees, room and board, books, supplies and other equipment (such as computers) for a student who is at least a half-time student, as defined by a certain number of credits carried per semester. While many states let you present a bill and have the program pay the institution directly, some states still have cumbersome verification procedures, requiring you to present receipts before getting reimbursed. Much of this process is getting streamlined, says Hurley, but because certain procedures are built into state law, it may take a while before the state legislature effects any changes.

Other features. The 529 programs managed by Fidelity and Salomon Smith Barney are linked to Upromise. Similar to membership miles or other affinity programs, Upromise takes a percentage of money charged on your credit card for specified goods and services and deposits it into your 529 account. The participating providers include McDonald’s, General Motors, ExxonMobil, Toys-R-Us, AT&T and supermarket and drugstore chains. (For a complete list, look up HYPERLINK “It’s what I consider an accelerator,” says Nottonson, who, with four young children, is always looking for ways to further squeeze a dollar into their 529s. “It’s important to have a plan and strategy for college savings, and once that’s in place, I use Upromise as icing on the cake.”

SIDEBAR: 529s for the older generation

For many parents and grandparents, 529s are the gift that keeps on giving.

Grandparents can use 529 plans to reduce the size of their estate by $11,000 per person ($22,000 per couple) per plan per year. Or they can take advantage of the accelerated gift tax benefit and invest up to $55,000 ($110,000 per couple) on behalf of each beneficiary in one year. While front-loading five years of gifting precludes any further deposits for another five years, “it takes advantage of tax-deferred growth over that period,” Nottonson points out. The only risk: If the benefactor dies during the five-year exclusionary period, the contribution is pro-rated and the amount associated with the remaining years goes back into the estate.

For many people, the most difficult aspect of estate planning is the actual transfer of assets to someone else’s control. But with 529 plans, you can subtract the money from your estate but still retain control over it. As owner of the account, you authorize all expenditures, ensuring that your namesake won’t blow his inheritance on a weekend in Vegas. You can even veto paying for a college that you don’t approve of. Furthermore, if the original beneficiary decides not to go to college at all, you can roll the portfolio over to another grandchild without any penalty.

Some far-seeing grandparents set up 529 plans for their grandchildren with a different aim than funding their college tuition. Instead, they intend to pay that generation’s college bills directly and leave the 529 money on the sidelines for use by future generations. While that’s perfectly legal, the money will be subject to a generation-skipping transfer tax (GSTT) of 50 percent. There is, however, a loophole, Pronek notes. Each donor is allowed a lifetime limit of $1,100,000 (recently raised from $1,060,000) in generation-switching gifts before the GSTT kicks in. Even taking college inflation into account, at least a few college educations should slide in under the wire.

While people naturally assume that the youngest generation should benefit from the 529 program, there’s no reason that you can’t designate yourself or an adult child as the beneficiary. Suppose you want to get an advanced degree. Over a period of time, you could stuff tens of thousands of dollars into a 529 plan that would eventually pay for your tuition, books and other qualified educational expenses – even housing, if that’s included in your choice of plan. In other words, you can use a 529 to fund a two- or three-year sabbatical as long as it involves part-time education at an eligible institution. Just make sure you actually attend. If you change your mind, you’ll have to pay state and federal taxes on the earnings, plus a 10 percent penalty.