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The Best and Worst 529 College Savings Plans for 2007

Our annual look at the state of the college savings industry.

Kerry O'Boyle, 03/06/2007

It has been another year of substantial change, much of it for the better, within the fledgling 529 college savings universe. Since our last review in February 2006, significant improvements on the tax front--on both the state and federal levels--have enhanced the appeal of 529 plans relative to other college-savings vehicles. In addition, management upgrades and fee reductions at a number of plans show that states are getting serious about providing competitive options for investors saving for their children's education.

Tax Changes
In the 529 world, the big news of 2006 was the signing into law of the Pension Protection Act of 2006. Among its many features, it made permanent the changes to Section 529 of the federal tax code made by the 2001 Economic Growth and Tax Relief Reconciliation Act--including investors' ability to withdraw earnings from 529 plans, free of federal taxes, for qualified college expenses. Until passage of the law, federal tax breaks on 529 plan earnings were set to expire at the end of 2010, casting a shadow over one of the most appealing aspects of these plans. Now, with that uncertainty removed, college savers can invest confidently in 529 plans knowing that their earnings will remain tax-free into the future.

The new tax law did not make permanent the 2001 changes to Coverdell Education Savings Accounts, however. Thus, unless Congress acts to address the college savings issue again, contributions to Coverdell accounts will revert to a maximum of $500 per year (down from $2,000) after 2010, and withdrawals for elementary or secondary school expenses will no longer be allowed without penalty. Coverdell accounts can still be rolled over into a 529 plan at any time, but the long-term appeal of these accounts now pales to a large extent in comparison with 529 plans.

On the state level, Maine, Kansas, and Pennsylvania all passed so-called "tax-parity" laws in 2006, which extend each state's tax deductions on contributions to residents who invest in out-of-state 529 plans. Previously, the standard practice had been to extend state tax breaks only to those who stuck with one of the home-state plans. It's unclear, however, how much traction this trend will gain among states, many of which have historically doled out benefits to encourage participation in their home-grown plans. Seven other states have reportedly considered similar legislation in the past, with nothing to show for it thus far.

In general, we favor such tax-parity because we think it empowers investors with greater flexibility to choose investment options more suited to their needs and personal risk tolerances. Still, tax parity is potentially a double-edged sword for college savers tempted to flit back and forth or chase performance, or for those persuaded to take their tax break and go out of state to a more expensive or conceivably worse plan.

Quality Is Improving
Despite some ongoing issues concerning broker sales practices, occasionally byzantine disclosure documents, and layers of fees, 529 plans have in general improved over the past few years. Since 2004 Congressional hearings on some of the above issues and industry concerns about less-than-expected asset growth, the states seem to have taken to heart the need to offer more competitive offerings. Until recently, few parents were tempted by 529s, given that so many featured lackluster offerings, high fees, and added complexity. Thus, wholesale changes have occurred at a number of plans in recent years.

Indeed, four of the seven plans from our 2006 worst list no longer exist or have changed providers. As expected, Wyoming got out of the 529 business entirely by merging its plan into Colorado's offerings. Arizona closed its high-priced PF and SM&R plans to new investors pending their eventual liquidation. And North Dakota dumped its poorly diversified Morgan Stanley plan for another of the seemingly ubiquitous Upromise/Vanguard options.

The trend toward low fees also continues. The disappearance of high-priced plans, like that from Wyoming and South Dakota's Core4College, has eliminated some of the most egregious offenders. The arrival of new providers with low-cost options, not to mention a handful of fee cuts at other plans, has sparked an increased measure of price competition among the states. That escalated to what one might call a price war in the fall of 2006. The planned introduction of a 0.5% all-index age-based option in California by Fidelity prompted Vanguard to cut fees by 10 basis points at its flagship Nevada plan to match it. Plus, economies of scale from industry-wide asset growth have also helped to push costs down at a number of plans.

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