Tax-advantaged 529 plans are popular with wealthy investors who are saving for their kids’ education, but they can have their drawbacks – Financial Planning

Clients who sock away funds in college savings plans seem to have a smart take on how to meet their offspring’s education costs. So why do so many parents leave money on the table?

The majority of people who buy 529 accounts do so through an advisor, rather than through a state program that sells them directly, the by-far cheaper option. Many advisors charge additional fees that eat away at the plans’ returns, leaving less to bankroll the $57,700-a-year sticker price at Yale and other elite private institutions.

But even fee-only advisors who forgo a commission and instead send clients to direct-sold plans may be leading them to invest dollars that might be better off in a tax-free Roth IRA. Some states, including California, New Jersey and North Carolina, don’t allow investors to deduct the money they contribute to a 529, negating one selling point of the plans. (There’s never a federal deduction.) Direct-sold accounts are usually more limited when it comes to a choice of underlying investments. The rules governing what can be withdrawn are complex — money taken out for something other than educational expenses is still tax free but carries a 10% penalty.

529 plans can be tricky to navigate when it comes to fees and share classes.

529 plans can be tricky to navigate when it comes to fees and share classes.

Bloomberg News

People who use an advisor to buy a 529 “see the value there and are willing to pay for the help,” argues John Boroff, the director of retirement and college leadership at Fidelity. “Those using an advisor are just comfortable in that space.”

But even for independent advisors who put a client’s interests above their own, there can be a financial cost for clients — and fiduciary cost for advisors — when accounts hold more than will be needed come college time. “You can be oversaving in your 529 and hurting yourself in retirement,” says CFP Kenneth Couser, the director of financial planning at Janney Montgomery Scott’s wealth management division, in Philadelphia. “Your savings in one can be to the detriment of the other.”

The plans are funded with dollars on which taxes have already been paid, with withdrawals tax-free when put toward tuition, housing, lab fees, books, computers and other college-related expenses. The tax perk, similar to that of Roth plans, has made 529s a growing financial niche that held more than $425 billion in assets in nearly 15 million accounts at the end of last year, according to the nonprofit collegesavings.org. Since the 2017 tax law went into effect, some states have allowed investors to use 529s for K-12 school costs. The pandemic relief package in December 2019 allows plan funds to be used to pay off a chunk of student loans, a major benefit. Investors who buy a state plan don’t have to send their kids to college in that state.

Money in the accounts has grown as the stock market rises and investors pour cash into the plans.

Money in the accounts has grown as the stock market rises and investors pour cash into the plans.

Financial Planning

The accounts are big with affluent families, even those who may be able to afford the soaring cost of college (the average is now $41,411 at private colleges, $11,171 for state residents at public colleges and $26,809 for out-of-state students at state schools). Seven in 10 families with incomes of at least six figures have one, according to Brookings. Wealthy investors tend to use financial advisors more frequently — around three in four of those with $1 million-$5 million of investable assets, and roughly four out of five with at least $5 million, work with an advisor — so they tend to choose advisor-sold plans over direct-sold.

So what are the benefits for advisors who sell 529s, and what are the drawbacks?

Going for fees vs. selling convenience

A 529 bought through an advisor or broker who charges commissions carries an average annual fee of 0.89%, according to Morningstar. Meanwhile, buying directly from states that offer the plans, which are managed by brokerages and asset managers, costs clients an average of 0.35% a year — nearly two-thirds less.

Advisor fees stem from the more-costly actively managed funds that advisor-sold plans typically invest in, and include “distribution” costs for marketing and selling (those hated 12b-1 fees). Depending on the class of share bought, there’s also an upfront commission of as much as 5.75%, according to Paul Curley, the director of college savings research at SS Market Intelligence.

Clients who buy a 529 through their brokerages can pay even more. A 529 through Morgan Stanley can cost “up to approximately” 2.56% a year and carry an initial sales charge of up to 5.75%, the Wall Street bank says.

Morningstar says that sales of direct-sold plans grew more than 7% a year from the end of 2015 through March 2020, while advisor-sold plans grew just under 3%. Still, the nearly one in three plans (32%) now sold by advisors is barely changed from a decade ago, when 36% were advisor-sold, according to data provided by Curley.

The plans have different share “classes” that are geared to how long an investor has before getting hit with tuition bills. In general, “Class A” shares charge an upfront commission and lower annual fees, while “Class C” shares have no front-end load but higher annual fees. Savingforcollege.com says Class C shares are a better deal if parents start later and have only a few years before their child goes to college. Getting the share class right for the number of years a parent plans to invest can make a difference of tens of thousands of dollars in savings. Fidelity’s Boroff says that because the plans are “purpose-built,” investors are more likely to use them.

Loreen Gilbert, the founder and CEO of WealthWise Financial Services, an RIA in Irvine, California, says that “it’s not just cost — we can help you navigate” the intricate rules, including how to make dollar-for-dollar withdrawals without a penalty when a child gets a scholarship, or how to structure plans so that they don’t count against financial aid. She cited one client who is an infectious disease doctor: “They don’t have time to do anything, so we can help.”

The risks to advisors and clients

Michael Harris, the chair of retirement studies at the College for Financial Planning, an educational company owned by Kaplan, says that brokers who put parents in Class C shares when a child is young risk running afoul of Regulation Best Interest, or Reg BI, an investor-protection standard for brokers that is lower than the fiduciary standard to which independent advisors are held. For younger kids, “it’s [economically] better to pay an up-front commission and smaller service charge, rather than no commission and a larger service charge.”

Since 2019, self-regulator FINRA has been scrutinizing brokerages that sold Class C shares, to generate hefty commissions, to parents of young children when another share class would have been more economical over time.

But even advisors who don’t get commissions and operate on the higher fiduciary standard can face a conundrum. A 2020 Journal of Accountancy article argued that Roth IRAs can be a better bet for situations where a high-achieving child’s scholarship equals or exceeds her qualified educational expenses that can be paid through a 529. Some RIAs put clients in no-load share classes and waive the annual fee, but charge clients based on assets under management (AUM), including the value of the 529.

Meanwhile, CFP Clint Haynes, the founder and president of NextGen Wealth, an RIA in Lee’s Summit, Missouri, says that “wealthy clients just assume they have to go through an advisor. Of course, the advisor may not mention that to them.”

Reporter, Financial Planning