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Advisers Like Incentives in 529s


Once an obscure, misunderstood college savings vehicle, 529 college savings plans now rival UGMA/UTMA accounts as well as taxable mutual fund accounts when it comes to the investments that financial advisors recommend most often to clients who are saving for college. A December 2001 study commissioned by Manulife Financial of Boston found that 74% of the 200 financial advisors surveyed sold 529 plans.

So what opened the door for 529s? First and foremost, advisors say it's the new tax law that eliminates federal taxes on qualified 529 withdrawals. The case for a 529 is even more compelling if, as in Michigan, the state offers additional incentives.

"Michigan's plan is run by TIAA-CREF and they offer investment choices, low expenses and low minimum contributions," says Portage, Mich.-based certified financial planner Sophit Lee. "However, my clients also respond well to Michigan's great incentive plan. In addition to a $5,000 deduction on state income taxes for single taxpayers and $10,000 for those filing joint returns, if the beneficiary is younger than 6, and if the family income doesn't exceed $80,000, there's a one-time match from the state up to $200."

In fact, 529 plans' tax advantages are so clear that 65% of the advisors Manulife surveyed noted that clients typically open a 529 account within two weeks of their initial presentation.

Choice and Performance

When it comes time to choose which 529 plan to invest in, 99% of advisors named a variety of investment choices as their top concern. Accordingly, many states have increased investment choices to offer more than the traditional age-based portfolios. Rhode Island recently added nine mutual funds from Alliance Capital of New York to its 529 plan, bringing its total number of investment options to 24.

While advisors and their clients appreciate more choices, current 529 investment options are still not enough for some. "We have an 11 year old and are very focused on her education planning," said Kathie Barnes, a certified financial planner in Phoenix. "However, we aren't motivated yet to invest in a 529 plan because we think the investment options will improve and we'll consider one then."

Advisors note that their clients' desire for choice stems from an underlying need for more control. In that regard, the new IRS ruling that allows investors to reallocate their 529 plans once a year has removed some roadblocks.

"Clients love flexibility," said Herbert Daroff, a certified financial planner with Baystate Financial Services in Boston. "Recent changes make the 529 more flexible, but didn't solve everything. What if I'm saving for Amherst College and my kid goes to University of Massachusetts? What happens to the extra money? Sure, I can roll it to another child but what happens when I run out of kids and don't want to tie it up long enough to give to my grandchildren? Ideally, in situations like this, there's an alternative to paying the taxes and 10% penalty on unqualified withdrawals."

In addition, performance was a top concern for close to 99% of the advisors Manulife surveyed. However, because 529s, launched in 1997, don't have a long-term record, advisors admit what they are really evaluating is the reputation of fund families.

The Manulife survey found many 529 investors are parents (51%) and grandparents (39%) saving for beneficiaries between the ages of five and nine years old. Three-quarters of the time, the birth of a child or grandchild triggers the purchase of a 529. An overall financial review (89%) and discussion of tax strategies (72%) also influence 529 purchases.

The survey also showed a wide range of household income levels among 529 investors. Fifty-seven percent had a household income between $50,000 and $100,000 and 29% had an income of $100,000 or more.

That statistic surprises Matthew Schiffman, president of Manulife Financial's Alternative Wealth Management division. "529 plans may offer even better benefits to the affluent market when one understands the estate planning applications for the product," he noted. "This points to a need for greater education, not just about the basics of these plans, but especially how these plans should be incorporated into a client's overall financial strategy."

Conversely, under-use of 529s by higher wage earners makes sense to Raymond Loewe, founder of College Money, a college-counseling firm in Marlton, N.J.. "Higher earners tend to be the investors who want more options and more control," he said.

Looking Ahead

Loewe notes that in an effort to offer something to every investor, Alaska has three plans run by different fund companies. He expects other states will follow Alaska's lead.

"If a state picks one fund company and sticks with it, the state could be perceived as recommending that fund company--and I'm not sure they want to do that. It's a matter of time before the 529 market gets flooded," he said. "As that happens, it will be more important than ever to do a detailed evaluation of the plans. Some plans have interesting idiosyncrasies. For example, in the state of New York, you have to stay in the plan for three years before you can take distribution."

With more fund companies on the playing field, the boom in investment choices and the possibility of new 529 rulings, advisors say they will rely more than ever on support from fund companies to help educate their clients about how 529s impact estate planning, tax management and financial aid. They'll also look for guidance on the number one 529 fear: the sunset provision on Dec. 31, 2010.

"Remember, the new tax law was written before Sept. 11th, before the President put an $80 billion deficit budget together," Daroff said, "You can't assume that money will be coming out free of federal taxes forever."