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In the past year, parents have been pouring money into the new "529" state college savings plans. Since the 2001 Bush tax bill exempted qualified withdrawals from taxes, the 529 plans have become one of the fastest-growing personal financial products in history. About $25 billion is now invested in 529 plans, three times as much as two years ago, and investors are expected to add $40 billion more by 2006.
Financial advisers and even Consumer Reports have been touting 529s as a miraculous way to save money for your children's college. They seem flawless. Unlike other tax-advantaged savings plans, the 529s have extremely high contribution limits and no income cutoffs. All earnings are tax-exempt if they're spent on education. The 529 plans are supposed to be an enormous federal tax subsidy for education.
But serious flaws in the 529s are being overlooked. The long-run potential of the plans has been seriously compromised by excessive "management" fees that states have added to these plans. In addition, all but a few of the plans limit investors to a single financial firm that offers only two or three investment options. The reality of 529 plans is that much of the tax subsidy is merely going to pay these higher fees to states and financial companies. Under some plans, families would actually do worse investing in 529 plans than in traditional savings instruments.
Take one of the most egregious examples, Arizona's InvestEd plan, operated by Waddell and Reed. Investing in its class "A" shares with the highest equity option, an investor must pay 92 basis points (0.92 percent of assets) per year for fund expenses and then another 91 basis points of state management fees. When you cash out, you have to fork over another 5.75 percent of total assets as a "sales load." The class "B" shares don't take the 5.75 percent final cut, but the extra management fee is 162 basis points, meaning the state and Waddell and Reed grab a whopping 2.54 percent of your savings every year.
Financial advisers and even Consumer Reports have been touting 529s as a miraculous way to save money for your children's college. They seem flawless. Unlike other tax-advantaged savings plans, the 529s have extremely high contribution limits and no income cutoffs. All earnings are tax-exempt if they're spent on education. The 529 plans are supposed to be an enormous federal tax subsidy for education.
But serious flaws in the 529s are being overlooked. The long-run potential of the plans has been seriously compromised by excessive "management" fees that states have added to these plans. In addition, all but a few of the plans limit investors to a single financial firm that offers only two or three investment options. The reality of 529 plans is that much of the tax subsidy is merely going to pay these higher fees to states and financial companies. Under some plans, families would actually do worse investing in 529 plans than in traditional savings instruments.
Take one of the most egregious examples, Arizona's InvestEd plan, operated by Waddell and Reed. Investing in its class "A" shares with the highest equity option, an investor must pay 92 basis points (0.92 percent of assets) per year for fund expenses and then another 91 basis points of state management fees. When you cash out, you have to fork over another 5.75 percent of total assets as a "sales load." The class "B" shares don't take the 5.75 percent final cut, but the extra management fee is 162 basis points, meaning the state and Waddell and Reed grab a whopping 2.54 percent of your savings every year.
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