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Is it time to 86 the 529 plan?

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For millions of parents and grandparents, opening a 529 plan to save for future college expenses has been a slam-dunk decision in recent years. No longer. In the aftermath of the $350 billion tax cut passed by Congress and signed into law by President Bush this year, the popular college savings vehicle holds a much smaller advantage than it used to.

529 plans were created by a 1996 tax law but were relatively unknown until 2001, when Congress significantly sweetened their benefits. Since then, the plans have been marketed heavily and grown rapidly in popularity. By the end of 2002, 3.1 million accounts were open with more than $20 billion in assets, up from $3.1 billion in 556,000 accounts two years earlier, according to Cerulli Associates.

For top money-management firms like Fidelity, Alliant and TIAA-CREF, the 529 plan “has been a growth market at a time when everything else has been going down,” said Luis Fleites, an analyst with Cerulli. “It has been a bright spot for a lot of firms.”

Fleites estimates total assets in 529 plans will rise 40 percent a year to $140 billion by 2008 — a healthy business but relatively small compared with retirement investment accounts like 401(k) plans, where Americans hold an estimated $1.6 trillion in assets, according to the Employee Benefit Research Institute.

529 accounts, offered by almost every state, allow investments to grow tax-free, and the proceeds can be withdrawn tax-free as long as the money is used for qualifying educational expenses, such as college tuition. But now that dividend taxes have been slashed and the top capital gains rate has been cut, the restrictions of 529 plans may outweigh the benefits for many investors, said Brent Brodeski of Savant Capital Management in Rockford, Ill.

“Except for certain unique situations they are not the de facto college choice anymore,” he said in an interview.

Brodeski prepared an analysis showing that a savvy investor could beat the return available in a 529 plan simply by making similar investments in a taxable account and then “gifting” the proceeds to his or her children during or just before their college years.

Even if the investor keeps the proceeds in a taxable account and then withdraws them at the highest marginal tax rate, the average annual return of the 529 plan is only 0.4 percent better on an after-tax basis. Under the old tax system, at the highest marginal tax rates, the 529 plan would have provided an annual return that was fully 1 percent higher, making it an easier decision to open an account.

Brodeski’s analysis assumes that Congress will vote to extend both the rules governing 529 plans and the new, lower tax rates on dividends and capital gains, all of which are scheduled to expire within the next decade.

The biggest disadvantage to 529 plans is that proceeds are taxed and penalized if they are withdrawn for any reason other than qualifying educational expenses. If a child chooses not to go to college, the parent or grandparent who controls the account can change the beneficiary to virtually anyone else in the extended family. But the plans still do not offer nearly the flexibility of an unrestricted, taxable account, Brodeski points out.

“The challenge is, who knows what the tax laws are going to look like 20 years from now, what all the different variables are going to be,” he said.

Still, Brodeski does not completely discourage clients from investing in 529 plans, which offer certain conveniences including automatic rebalancing according to the age of the beneficiary. When it comes to college expenses, he said, “What I like to tell people is it doesn’t really matter where you save it — as long as you save it.”

529 plans are still an ideal vehicle for older investors who might want to set aside college money for their young grandchildren and then forget it, for example. They also might be an excellent choice for investors who want to shelter money from a state income tax, assuming they have a good in-state option for 529 plans.

Joseph Hurley, an accountant who runs a Web site that focuses exclusively on 529 plans,, concluded that they still hold advantages, especially if investors make sure to choose a plan with low fees and expenses. “The new tax cuts may slightly dim the sparkle of 529 plans, but because of their multiple benefits, 529s will remain attractive and important to many investors,” he said in an article on his Web site.

But Brodeski said 529 plans are no longer the “panacea” they appeared to be just two years ago.

“Before they were too good to be true,” he said. “Now they are merely interesting.”