Who's Giving Advice On 529s?

I suppose it had to happen. When congress made college savings plans free of federal tax starting this year, brokers and financial planners trumpeted the news. Now we've got an epidemic of misleading sales pitches. What's more, these plans aren't suitable for everyone.

At issue are college 529 plans, named after the section of the federal tax code that permits them. Each state establishes its own plan--42 have them so far and the rest hope to offer them this year. Briefly, here's how these saving-and-investment deals work:

You contribute money to the 529 in regular payments or lump sums. The states arrange for several investment options, usually including a stock fund, a fund with both stocks and bonds and a guaranteed-interest account. Gains grow tax-deferred and can be used, tax-free, for higher education at any accredited U.S. school.

You're free to change beneficiaries at any time. If the child doesn't use the money, you can roll it into a 529 for someone else in the family, including first cousins. Accounts can grow as large as $269,000, depending on the state, before contributions have to stop. On any withdrawals for purposes other than school, you'll owe income taxes and, usually, a penalty of 10 percent.

Financial advisers will almost certainly explain all this. What they may not mention is how state income taxes enter the picture.

So far, 23 states let you deduct some or all of your contributions from your state tax. In New York, for example, you can deduct up to $5,000 a year ($10,000 if you're married). Mississippi lets you write off up to $10,000 ($20,000 for couples). In Colorado and New Mexico, you can deduct every penny you put in.

To get a state-tax deduction, you have to live or work in that state and choose its 529. But advisers might bad-mouth that plan's performance if it doesn't pay commissions. You might be urged to choose another state's 529--losing a tax write-off.

This came to my attention when a friend called me with a question. She'd gone to a planner to talk about starting 529s for her two grandchildren. Even though she lives in New York, the planner urged her to buy the Ohio plan. It's managed by Putnam and pays salespeople commissions of up to 5.75 percent (plus small commissions in future years). He told her that she might as well buy from Ohio because New York has no state-tax deduction. Wrong.

I understand that salespeople don't want to mention the competition. But they certainly shouldn't mislead you about another plan. (My friend ditched that planner, fast.)

NEWSWEEK started making calls to see what other salespeople said. Many seem to be badly trained. Michael, a phone rep at Allfirst bank, which also sells the Putnam plan, said there were no tax deductions for 529s. Wrong. At HSBC Brokerage, a rep who wouldn't give her name said a New Yorker should buy the Rhode Island plan, run by Alliance Capital (commissions: up to 4.25 percent). She claimed that New York's plan taxes investors when they take college money out. Wrong again. HSBC says it will take steps to get every rep up to speed. Alliance is reprinting its 529 brochures to mention the state-tax option. Only at T. Rowe Price, which runs Alaska's 529, did the phone rep, Dave, volunteer that New York's plan offers tax deductions.

You have to be careful about Web sites, too. At the Strong Funds' 529 site, you're invited to "select your state." That click almost always leads you to Strong's Wisconsin plan. ("We assume you want our plan," Strong says.) The brokerage firm Schwab sells the Kansas plan and keeps mum about checking with your state.

How come states are teaming up with commission-paid brokers and planners? Mostly because they want larger plans and need salespeople to bring customers in. Some states earn revenue from the plans in the form of enrollment and administration fees, which only out-of-staters might pay. A few get a percentage of the plan's total assets, says 529 expert Joseph Hurley.

What if you live in one of the seven states with no income tax or one of the 16 states with no write-off for 529 contributions? "You should still look at your state program first," Hurley says, "then compare it with other plans." If you sign up through the state (as most plans allow, even if they also sell through advisers), you'll be investing at a lower cost.

The huge teachers' pension fund, TIAA-CREF, runs national, low-cost, no-load plans for 14 states, including California, New York and Michigan (it's considering a broker-sold version, offered at a higher fee). Fidelity Investments runs national no-load and broker-sold plans for three states, including New Hampshire.

For the details, ratings and performance of all state plans, check Hurley's excellent Web site, savingforcollege.com. The un-Webbed can get information on any state's plan from the College Savings Plan Network, toll-free at 877-277-6496.

Coming up next--529s for the workplace. But will disclosure be any better there? Raytheon Co., based in Massachusetts, will offer Fidelity's plan this spring. Employees may deposit a portion of their paychecks, automatically, into New Hampshire's 529.

Massachusetts doesn't offer a tax deduction for its own 529, so workers there can readily join a different plan. But Raytheon will not tell workers in other plants what write-off they could get in a state 529. They should "do their homework," a spokesperson says.

Whether to join a 529 at all depends on your income. It's a no-brainer for the well-to-do. But a little-known tax angle could jolt couples earning up to $82,000. In that bracket, you get a tax credit on your federal return to help pay college costs. But you can't use 529 plans, tax-free, for the same expenses that the credit covers.

For example, take the Lifetime Learning credit. Next year you can write off 20 percent of your first $10,000 in college tuition. But then you'd have to pay the school $10,000 out of pocket (from cash or loans) before you can use your 529 plan tax-free. You lose your tax break--and will owe both state and federal taxes--on any 529 money that you're forced to use upfront. Surprised? So was I. Unless the law changes, a 529 is mostly a higher-income game.