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A Short Course in college savings plans

August 30, 2002
Related Topics: Finance/Taxes, Benefit Design and Communication, Featured Article, Compensation
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Nary a day goes by without a Madison Avenue bombardment of ads hawking thehottest topic in financial services: Section 529 plans. Simply stated, the dealsare college-savings plans with tax advantages that address and exploit a primaryfamily financial concern.

As the plans gain widespread acceptance, they are increasingly becoming amust-have benefit for any company looking to offer a competitive benefitsprogram. If you wish to attract and retain key employees, you should consideroffering this program. As with any new benefit, however, there are pitfalls thatinformed human resource executives should be aware of.

It is, of course, easy to understand why the plans are so inviting. Collegecosts are fast becoming out of reach for the average household. Studies haveshown that college costs have risen at twice the rate of inflation for most ofthe past two decades. According to the College Board’s annual survey “Trendsin College Pricing,” by the time a child born today enters college in the year2020, the cost of a four-year education at a public university will be more than$85,000. The price at a private institution: a staggering $225,000.

To help offset these expenses, the federal government created Section 529plans in 1996. Though they have evolved since then, the basic premise is toprovide a tax-advantaged plan to help people save money for college expenses. Inaddition, there is an estate-tax benefit that removes the assets from the donor’sestate and allows donors to accelerate the use of the annual gift-tax exclusion.The Economic Growth and Tax Relief Reconciliation Act of 2001 has made theseprograms even more attractive by allowing qualified withdrawals to be takencompletely free of federal income taxes when used to pay for qualified educationexpenses—at least through 2010. These expenses include tuition, room andboard, books and fees, and any other required student expenses at any accreditedcollege or university in the United States. Previously, withdrawals were taxedat the beneficiary’s rate. According to the College Savings Plans Network, anaffiliate of the National Association of State Treasurers, more than 3 millionchildren across the country are enrolled in a state college-savings plan. Assetsin these programs now exceed $18.3 billion.

What to watch out for
In selecting a 529 plan, it is important to shop around. Established mutualfund companies and 401(k) providers such as Fidelity Investments, PutnamInvestments, TIAA-CREF, Vanguard, and Merrill Lynch have rushed into theexploding marketplace to offer and create their own proprietary solutions.Typically, insurance or 401(k) vendors will describe the plans as “just like a401(k)” but easier to administer. Most will say there’s no cost to thecompany, and virtually no work or maintenance—no plan documents, no ERISAprovisions, and no non-discrimination testing. It is commonly said that there isno liability involved, since companies technically aren’t sponsors but aremerely facilitating the benefit by offering it in the workplace. Also, unlike anEducation IRA or other vehicles, 529s have no age or income restrictions, thusallowing parents, grandparents, and even family friends to contribute to abeneficiary’s account. Plans are available for post-tax payroll deduction ordirect deposit to make it easier for employees to save.

The reality can be quite different. The plans, in fact, aren’t all thesame. The federal government authorized individual states to oversee theseprograms. Subsequently, there are now about 50 different programs available, allwith varying features, capabilities, and tax benefits. Some states offer statetax deductions for residents using their own state’s plan. In many statesthere is no advantage to using the in-state program. Generally, an employershould consider both in-state and out-of-state plans. Many investment firmslimit the number of programs that their representatives can work with. Mostmutual fund companies and 401(k) providers that offer 529 plans will work onlywith their own programs, regardless of state-specific tax benefits. A goodquestion to ask is: “Am I being offered the best plan for my company or simplythe best—or only—plan that a vendor can sell?” To find out, consider thefollowing factors:

    Coverage. Can the plan provide all of the available tax benefits to all ofyour employees? There are certain states that offer an additional tax credit forresidents contributing to their home state’s plan. Not considering thestate-specific tax benefits can be unfair to employees who could qualify forsuch benefits and can potentially expose your company to liability. If yourvendor cannot or will not support these plans, be sure to find a vendor thatwill.

    Practicality. Does the plan offer low monthly minimums for rank-and-fileemployees as well as high maximum contributions for wealthier employees who wantto take advantage of the estate-tax benefits? Some plans offer minimumcontributions as low as $15, while others require $500 up front or $50 per fundper month. As for the maximums, there are some plans that give people theability to invest up to $300,000, while others cut off donors when the accountreaches $100,000. This can have significant impacts on covering education costsand managing the estate planning.

Corporate Ease of Use. Not all plans have payroll-deduction or direct-depositcapabilities. Even if they do, some have Internet enrollment features that makethe plan easier to administer. Most important, confirm what your broker oradviser is willing to do for you. Will they handle all of the paperwork? Willthey support multiple plans? Will they answer employee questions so you do nothave to? If the answer to any of these is no, then your “no-cost” plan willstart to incur the costs associated with your time and effort.

Investment Flexibility. How many investment options does the plan provide?Many plans still provide just one age-based investment option—“set it andforget it.” This option allocates the donor’s money across a variety offunds according to the beneficiary’s age. When the child is very young, mostof the money sits in equity mutual funds. As the child ages, the portfolio ischanged until it invests primarily in money market and bond funds when thebeneficiary is 16 or older. This may not be ideal, especially if the intentionis to use the money for the child’s graduate school or the donor’s owneducation years from now.

To address this lack of flexibility, some plans offer static portfolios thatremain the same no matter what the beneficiary’s age. The latest featuresallow donors to select individual funds and truly customize their portfolios,including more conservative fixed-income options. In today’s nervousinvestment environment, participants are increasingly seeking greaterfixed-income or bond-fund choices. The extent of these offerings varies greatlyby program.

Investment Pricing. Some plans are similar to 401(k) plans. They providepricing discounts that waive certain fees and/or sales charges and surrendercharges for employees if the plan is offered through the employer. In somecases, the differences in expense ratios, and subsequently the returns on theinvestments, can be quite dramatic. Again, this is a critical issue when askingwhether this is the best plan for your company or just the best plan a vendorcan sell. Also, many fund companies try to hide their newer funds with higherexpense ratios in these programs so they can quickly build up more assets.

Investment Quality. True, most investments into these programs are placedinto age-based asset-allocation portfolios. So, in theory, over time theperformance records of these portfolios should start to mirror one another (lessexpenses, of course). However, you should lift up the hood on what employeeswill be investing in. Ironically, these programs are marketed on the basis oftheir tax advantages and no-cost, low-maintenance administrative requirementsfor the employer, but the underlying investments are often downplayed. Manyprograms offer portfolios with widely overlapping funds in them, thus defeatingthe purpose of a diversified asset-allocation portfolio. Likewise, due diligenceshould consider any overlap with the existing 401(k) investment choices in orderto further reduce any overlap.

    Support. Just as some mutual fund companies may not have the experience orback-office capabilities to be the vendor for your 401(k) plan, the same can besaid of 529 plans. For example, one company that sponsors multiple state planshas an enrollment staff of only three people, while another popular provider hasa participant call center with a staff that can be counted on one hand. Moreimportant, your vendor and/or adviser should be able to provide education andanswer questions about 529 plans and other college-savings vehicles like UGMA/UTMAaccounts and Coverdell Education Savings Accounts (formerly Education IRAs).Ongoing support should also include separate estate-planning education foremployees concerned about the unique “gifting” guidelines offered in a 529plan, along with awareness of and enrollment assistance for shopper-loyaltyprograms such as Upromise and Babymint.

Before rolling out the program, survey your employees to gauge the interestlevel and to assess the impact on 401(k) contributions that a competing savingsprogram might have on your company. Inquire about how ex-employee 529 plans willbe handled. These programs are highly portable benefits that can travel withemployees long after they leave the service of your company.

A properly administered 529 plan can achieve ease of administration and highparticipation levels at no cost to the employer. However, chances are that thevendor at your door can offer only one or two plans. As the plans change, youmay find that you purchased a product, not an ongoing solution. An ill-conceivedand improperly executed program can lead to a plan that is “no-participation”instead of no-cost, no-maintenance, and no-liability. Remember, these plans arestill relatively new and continue to change and evolve. In the last 12 months,529 programs have improved dramatically in terms of the investment selections,data, and number of choices available to employers and employees. Because thistrend should continue, employers would do well to look for a flexible solutionthat works for them.

If you find yourself overwhelmed by the choices and sheer volume ofinformation, an independent adviser may be able to help. An independent advisercan also coordinate the implementation and education processes and make theprogram(s) more manageable.

Workforce, September 2002, pp. 50-55 -- Subscribe Now!

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