Dollars & Sense April 18, 2002

Go Back to Archives	"Dollars & Sense" By Tom Haugh - Chief Investment Officer

529 Plans: Is a Great Idea Being Ruined? April 18, 2002

We get a lot of questions from our PTI clients regarding investments for specific purposes and how to save for future college education expenses is a frequent inquiry. We could join the debate as to why increases in college education expenses have generally outstripped rises in the general price level, but it would probably be better to concentrate on figuring out how to pay for them. One of the most powerful tools for doing just that are the recently devised 529 Savings Plans, named after the section number in the IRS code authorizing their creation. These plans are sponsored by the individual states and are generally similar in design, but can have significant differences in state tax treatment, plan flexibility, and plan performance.

The strong points of these plans generally hold true for all the state plans:

Tax Relief - The contributions to the plan are not tax deductible on the federal level, but all earnings accumulating in the plan are tax deferred. Withdrawals are also currently tax free on the federal level but that advantage is due to expire if not extended in 2010. If not extended the taxation of the plan income will be at the tax rate of the recipient. Some states allow similar deductions for withdrawals on state tax, some also allow deductions on the original contributions, and some give no state tax break.
Control - The most unique advantage of these plans is the ability of the donor to retain control of the funds. Unlike some previous plans which required that the funds pass to the recipient at some predetermined age (with the chance that they could be used for a Corvette instead of tuition) these funds remain under the total control of the donor. That generally means that the beneficiary can be changed at a later date, that the donor himself can become the beneficiary, or that the funds can be simply withdrawn with a small penalty and tax liability on the money earned. Again, there are some small nuances to be aware of in individual state plans.
No Income Restrictions - The plans are open and the advantages available for people of all tax brackets, and most states allow generous numbers in excess of $200,000 to benefit from the plans.
Gift Tax Relief - Even though the maximum allowable gift to an individual is $11,000 in any year, these plans allow someone to use five years of this deduction at one time. For example, a grandfather or grandmother could give $55,000 to individual beneficiaries in one lump sum to remove those monies from the estate.

So what is wrong with this picture? There are enough differences in the state plans in regards to tax treatment, performance, fees, and other issues that the average investor could use some help in determining whether his home state plan is the best for him. Since most state plans allow out of state investors, some of those sponsors are aggressively marketing their plans without regard to their appropriateness or advisability in another state. For example, Tom Lauricella wrote an interesting article in the The Wall Street Journal on April 16, 2002 entitled “Some College-Savings Plans, Done at Work, Miss Tax Perks”. In this article he outlines the story of how Alliance Capital Management LP, the manager of the Rhode Island state plan succeeded in convincing a Michigan firm named Tower Automotive Inc. into signing up for a wage deduction company plan based on the Rhode Island plan. Make no mention of the fact that the Michigan plan would have provided for $10,000 in deductions towards state taxes or that the Michigan plan has a very unique money matching plan for low income investors.

Other issues we have encountered at PTI that subtract from the attractiveness of these plans:

Excessive fees - Some plans have low fees, for example New York charges .65%. Some others are seemingly too high. Illinois charges .99% for both the equity and fixed income plans, moderately high, where the manager of Wisconsin’s index fund, the Strong Funds, charges 1.25%, laughable in comparison to Vanguard’s index funds where they charge less than .25%.
Uneven loads for outside brokers - I can’t believe this one. Some plans allow for an outside broker-dealer to charge a customer an additional load on his investment since they do not want to share the ongoing management fee. This means that the product could be a lot more expensive to one customer than another. While we are not opposed to a reasonable load, the fact that they may be unevenly applied is troubling. In fact, this uneven pricing has caused us to recommend to several of our customers that they apply to the issuer directly. The experience of one PTI customer contacting Solomon Smith Barney in Illinois was encountering a Smith Barney broker who was unfamiliar with the plan and who tried to steal his account (which did not work). It also creates an incentive for brokers to recommend a state plan that provides funds to the broker, not always the best for the investor.
Lousy performance - The performance of these funds has been uneven, and in some instances, pretty bad. The web site www.savingforcollege.com keeps track of the performance, and the accusation can be made that the states are less than outspoken with bad results. The Illinois state treasurer, Judy Topinka, actually wrote a letter a while back to the Chicago Sun-Times bragging about the return in the fixed income fund, ignoring the losing returns in the equity fund.
Difficulty in comparison - Since there are so many moving parts, and pending legislation, comparisons are difficult. An example would be in comparing the Illinois fixed income plan with that of another state. Illinois charges a fairly high fee of .99% to manage that fund, but gives an income tax break on contributions, income earned, and withdrawals. If another state charged a .60% fee, and the Illinois tax rate is 2.5%, on a 6% annual return, the break even between Illinois and the competing state would be around 8 years.
Number of investment vehicles - Although it seems that states offer too few investment choices, usually a fixed income fund, an equity fund, and some hybrids, when you consider all the funds available in all the states, it becomes a huge number to compare. That is in addition to the tax and fee issues discussed previously.

At PTI Securities we have been dealing with the questions and concerns and giving advice to current customers on a case by case basis. The increasing popularity of these plans may cause us to adopt a more formal and aggressive plan to assist our customers in the future (if feedback from our clients indicates the need). We would certainly appreciate any feedback, including any details of your personal experiences with 529 Plans. Feel free to e-mail me at tph@ptihedge.com.

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