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New Suitability Regulations Could Slow 529 Growth


As college financing plans evolve, so do the rules about selling them. The Deficit Reduction Act of 2005 is making prepaid college tuition plans more attractive. At the same time, as states add special features to their 529 plans to attract assets from both in-state and out, regulators want to make sure sellers disclose exactly what those bells and whistles entail. Meanwhile, the future of 529s may depend on extending the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which expires in 2010.

College saving 529 plans have been growing rapidly. According to Financial Research Corp., assets in 529s rose 30.8% in 2005, to $68.4 billion. This is good news for advisers, mostly those working with broker/dealers, who manage between 66% and 75% of 529 plan money. The plans got a big boost in 2001, when EGTRRA converted them from offering tax-deferred status for invested assets to tax-free status, as long as withdrawals pay for higher education.

This year, the 529's sister program, prepaid tuition plans, got their own boost from the Deficit Reduction Act of 2005. Prepaid plans had counted as student assets, making it harder for participants to qualify for financial aid. But under the new law, which takes effect in July, prepaid plans count as parental assets. The act could help regular 529s, too, by stipulating that transfers to these plans from custodial accounts for minors are also considered parental assets.

This may not solve the problem completely, said Kalman Chany, author of "Paying for College Without Going Broke." "No matter what the Feds do, nothing will prevent the colleges from awarding funds according to their own rules," Chany said.

Nonetheless, FRC projects assets in 529s will approach $200 billion by 2008, and for good reason: the benefits are substantial. The plans let investors make large, catch-up contributions (up to $55,000 per year, per child without triggering the gift tax) for children and grandchildren who can then withdraw gains without paying any Federal taxes. Plus, many states allow tax deductions for contributions.

Meanwhile, some plans are getting more complex, offering a wider, cheaper range of investment options as well as greater flexibility. For example, some plans allow clients to switch beneficiaries.

"The programs are providing more investment choices, lower fees and an improved product," said Joe Hurley, CEO of Savingforcollege.com, in Pittsford, N.Y.

There's a catch to all these add-ons, though. While the complexity of the plans gives advisers an opportunity to provide guidance, it has also opened the door to abuses. Last October, NASD charged Ameriprise, a former unit of American Express, for putting clients from all states into a single Wisconsin plan without disclosing that it was managing the plan. The ongoing brunt of the criticism is that some advisers have ignored their fiduciary duty by favoring fee-generating, out-of-state plans over in-state plans that provide tax breaks. NASD Vice Chairman Mary Schapiro said that the association is "looking into whether advisers for some big financial firms are recommending out-of-state plans to customers because they earn commissions for selling those plans."

More surprising are the hefty management fees many states rake in. Rather than seeking to help residents, many states view their 529 plans as sources of revenue.

As a result of these problems, the Municipal Securities Rulemaking Board (MSRB) issued proposed rules in December requiring brokers to do a comparative analysis of 529 plans when recommending them to clients. But under industry protest, the board backed off and issued much less stringent requirements. The new rules require advisers to do an "active suitability analysis" of recommended plans and disclose when clients are forfeiting a tax break by choosing an out-of-state plan. Broker/dealers are also supposed to apply the same standards to marketing performance data on 529s as they do to mutual funds.

"If you are going to market out-of-state plans, you have to reveal information about taxes as well as performance," said Kit Taylor, executive director of the MSRB.

While advocates like the new rules, some planners see little difference. "Since I go out of my way to find prudent plans, I don't see added disclosure as a big factor," said Brad Rosley, a planner in Glen Ellyn, Ill.

Longer-term, EGTRRA is set to expire at the end of 2010, taking with it 529's tax-free status. Unless Congress extends it, the plans would revert to being tax-deferred, but withdrawals would then be taxed at the level of the presumably impoverished graduate.

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