529 Plans: A Taxing Subject

If you're an advocate of states' “rights,” the 529 college savings plan is the investment choice for you.

Started by Congress in 1996 and named after the section in the IRS code that permits them, these investment programs are run by state governments and are regulated as municipal securities by the Municipal Securities Rulemaking Board (MSRB). Therefore, states can pretty much do what they want with their plans, which totaled about $20 billion in assets at the end of 2002.

Just about every state, plus the District of Columbia, offers at least one, and sometimes several, 529 options, with a crazy quilt of fees, expenses, styles and managers. “It's a Wild West show out there,” says William Solomon, an advisor with William L. Solomon in Plainview, N.Y., affiliated with Cadaret & Grant.

As you might expect, state tax treatment is no exception to the chaotic rules. Earnings on withdrawals from the plans are exempt from federal taxation, for example, but some states choose, incongruously, to tax such proceeds. Further, about half of all states offer some form of tax deduction for contributions, but the specific amounts are, as it were, all over the map. Plus, a number of individual states have their own idiosyncratic policies related to tax issues.

“It certainly is another complexity in an already complex product,” says Luis Fleites, a senior analyst with Cerulli Associates in Boston.

Beating the Tax Man

The biggest consideration for advisors is the tax deduction for contributions. Some 24 states offer one to in-state residents who invest in their home state's plan. In some cases, like Colorado and South Carolina, there's no cap on how much an investor can deduct. In others, there's a limit, ranging from Rhode Island's $500 a year ($1,000 for joint filers) to Mississippi's $10,000. Recently, a handful of states have also considered extending deductions to contributions to out-of-state plans, too. Such efforts to “level the playing field,” as advocates call them, have failed, so far. “States are in a fiscal situation where things like that may not make sense for now,” says Jeff Coghan, 529 product manager for Alliance Capital.

At the same time, the fact that your client gets a tax deduction for contributing to an in-state plan doesn't necessarily mean you should choose that investment. The key is boiling down the deduction to a dollar amount. A client in the top tax bracket in, say, Wisconsin, which offers a $3,000 per-beneficiary deduction, would have $180 a year in tax savings, according to Sarah Heriksen, director of Education Planning for Strong Financial. “That may be substantial to some people and insignificant to others,” says Henriksen. In those cases where the effect is underwhelming, it may be more important to choose a program with the best performance and most-cost-effective underlying expenses — or, at the very least, not to make the tax savings the most important factor in choosing a plan.

That's the philosophy of Michael Amato, an advisor with Independent Tax & Financial Planners in Holland, Pa., an affiliate of broker/dealer HD Vest. He recently advised one client, an Ohio resident in the top state tax bracket with three children, to invest in Ohio's plan. That decision was made not because of the tax savings — the tax benefit would only have been $420 a year — but because the client seemed comfortable with the plan's investment options. In another case, Amato counseled a client to eschew an in-state plan and to forgo the deduction completely because he didn't like the underlying fund performance. “Don't let the tail wag the dog,” he says.

State/Federal Interaction

One of the most important state tax issues relates to piggybacking — that is, whether states conform to the federal tax exemption on qualified withdrawals. All states piggyback on the rule when it comes to in-state residents' distributions. Non-qualified withdrawals, on the other hand, are subject to tax. At the same time, in some places, like Alaska, distributions for state and non-state residents are taxed at the beneficiary rate. So, if clients want to use some of the money for a daughter's wedding, they can do so at her, presumably lower, rate.

Earnings from out-of-state plans are another matter. A handful of states tax those withdrawals — and the states that do so keep changing. Last April, for example, the Maine legislature, as part of an automatic budget-balancing bill, eliminated tax-free withdrawals. Three months later, they reinstated it. “They realized they weren't going to raise much revenue when all was said and done,” says Joe Hurley, a Rochester, N.Y.-based 529 specialist who heads savingforcollege.com.

The biggest stink was probably caused last year when the Illinois legislature voted to take away residents' tax break from any plans other than the two in-state 529s — Bright Start, managed by Smith Barney, and College Illinois, a prepaid tuition program.

How important a role do taxes play in the decision of whether to invest in a state plan? Depending on the client's state tax rate, not very, according to many advisors. “Since you're only paying tax on the gain, a lot of other factors have to be taken into consideration,” says Richard Sawyer, an advisor with Norton Financial Services in South Portland, Maine, who is affiliated with Commonwealth Financial Network.

John Kelty agrees. An advisor with Kelty Financial Services in Glenview, Ill., Kelty says his advice hasn't changed since Illinois changed its rules. Recently, for example, he convinced a client to invest in his favorite choice, Alaska's program managed by Manulife, even though she'd have to pay a 3 percent tax on withdrawals. The tax she'd pay is “a non-event,” he says. “Performance is more important.”

The Trouble With New York

Perhaps the thorniest of state programs is New York's. One of the oldest plans, it recently announced a first for any 529: a complete change in its manager (see sidebar). What's more, last year, the New York State Department of Taxation and Finance, through an administrative rule change, announced that it would treat rollovers to out-of-state plans as nonqualified withdrawals. That meant, for starters, that rollovers would trigger the recapture of previously taken deductions; New York allows taxpayers a $5,000 deduction, or $10,000 for married couples filing jointly. What's more, the earnings portion of the distribution would be taxed.

For many advisors, the change was a tiebreaker. “Before the change, I advised clients to take advantage of the tax deduction,” says Edward Neugroschl with Finesco Associates in Brewster, N.Y., an affiliate of Walnut Street Securities. “Now, I tell people most of the time, under no circumstance should they put any money into the New York plan.” He points to a client in the top state tax bracket who, after making a $10,000 contribution, would have a net tax savings of about $500. “That doesn't justify the potential tax liability,” he says.

Will other states follow New York's lead? “Most realize the cost of administering the change costs more than any revenue gain,” says Hurley.

To reduce the chances of such changes occurring in other places, 16 investment heavy-hitters, including Strong, Merrill Lynch and Fidelity, recently joined forces to create an education and lobbying group. Called the College Savings Foundation, its mission, among other things, is to address a variety of state and federal tax issues.

The taxation maze, for advisors, is a decidedly a mixed blessing. On the one hand, it means investors need guidance, but “the complexities might also be dissuading interest and preventing people form understanding what the benefits really are,” says Shannon Zimmerman, a mutual fund analyst for Morningstar.

The 529 savings account penetration rate for children under age 18 in 2002 remains very low — only 4.3 percent, according to Cerulli.

Can we ever expect significantly more uniformity in state taxation approaches? Probably not, say some analysts. “Uniformity will be slow to come,” says Fleites of Cerulli Associates. “States have their own considerations and goals. And they're the ones basically in control.”

The State of 529 Taxation

These states offer tax deductions to their residents.

A New York Moment

New York state shakes up its 529 plan by changing managers. Is your plan manager next?

Earlier this year, New York State shocked the 529 world with an unexpected announcement: When its five-year contract expires at the end of this year, it will drop its existing manager, TIAA-CREF, in favor of Upromise Investments. It was a big deal, in part because it involved TIAA-CREF, the biggest 529 program manager in the country, with $3.1 billion in total assets at year-end 2002. What's more, with $1.8 billion in assets, the New York plan was a juicy prize for any company to win. Plus, under TIAA-CREF, the plan had only been sold direct to the public. The new arrangement changed that to a two-part system: a direct component, distributed by Vanguard, and an advisor-sold option, through Fleet Bank's Columbia unit.

Of course, New York isn't the only state that has made changes in its 529 line-up. New Jersey, for instance, switched to Franklin Templeton for both a direct and advisor-sold option. A year ago, California put out a request for proposals for a broker-sold 529. Still, New York's is by far the most significant change yet.

For advisors, it opens the possibility of offering the New York plan to clients and getting a piece of the action. (That's if they don't mind changes made in rollover provisions made last year). At the same time, however, reps are in a sort of no-man's-land, since Upromise hasn't yet announced the specifics of its new plan.

The big question, of course, is whether or not this a harbinger of things to come. Are major changes in the offing in other states? In May 2004, Missouri's contract with TIAA-CREF is up for renewal, and California's expires in 2006.

“It's impossible to say if we'll see more changes,” says Joe Hurley, a 529 plan expert, who runs savingforcollege.com. “But advisors have to understand that, when they select a 529 plan, the program manager may not be with them forever.”
— AF