Tread Carefully when Encountering 529s

Physician's Money Digest, December31 2003, Volume 10, Issue 24

If you have children or plan to take college courses in the future, you should take full advantage of 529 college savings plans. They offer one of the best tax breaks available. The plans are available to everyone. However, Congress has made these plans very complex and inflexible. Here are key issues to be aware of.

Seize Advantages

The following are the key advantages of 529 plans:

As long as the money is used for higher education-related expenses, there are no taxes on withdrawals or investment returns.

  • Some states offer a state tax deduction with their 529 college savings plans.

All states' 529 plans are available, regardless of residency, and for each child, multiple accounts can be opened in different states.

  • The money can be used for most education-related expenses (eg, room and board, textbooks, etc).

Although each 529 account must have a designated beneficiary, the money can easily be transferred to other related beneficiaries.

  • You can save your desired amount at any rate, without advance commitments.

Recognize Disadvantages

Be aware of the following disadvantages and complexities of 529 plans:

  • Unlike IRA accounts that you can open at any financial institution with many investment options, you have to participate in one or more state-sponsored plans.

Each state decides who manages the investments, your investment options, your fees and other costs, etc. The options are not always good, and the plans are generally inflexible.

  • Many states are starting to look at 529 savings plans as a source of revenue. Consequently, the fees and cost are rising.

Many plans offer the equivalents of load funds and high-expense ratio funds, which can be a drain on your savings. If you're not careful, your broker or financial advisor will most likely steer you toward one of these.

  • It may sound wonderful that you have so many options, but in reality, you have a lot of inflexible, bad choices to wade through, wasting time and energy.

Use Some Tips

So what's a busy physician-investor to do? Unless you are knowledgeable about investing, seek competent, unbiased professional help. Because of the various inflexibilities, managing a 529 account is more complex than managing other investment accounts. Find a fee-based advisor who won't steer you into plans they are compensated for.

Key decisions:

• Investigate the plan's fees. Never invest in a plan or investment option that charges front- or back-end loads. As with mutual funds, if the investment options have A, B, or C tacked to the end of their names, turn and run. These are traps you will live to regret. At what rate do you need to save for each child, which state's plan should you use, and which investment options should you choose? Your financial advisor can help with all these decisions and explain their recommendations clearly and convincingly.

• View and manage investments in 529 plans as part of your overall portfolio. This is very important and should be reflected in the investment choices you make. Start saving early, and save steadily. Let me cite one number to motivate you to start saving right away. If you just had a baby and want to save enough money to send them to a private college, you would probably have to save $10,000 per year, increasing savings at the rate of inflation (ie, maybe $10,300 next year) until they are ready to attend college. Admittedly, this is a somewhat conservative estimate. But if your investments do well over the years, you will be able to stop saving earlier, which is something to look forward to.

Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2002), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.