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Commissions are devouring your 529 earnings gains

Cost-conscious investors are pouring money into self-directed plans

Fee awareness is up among investors in college savings plans, and it may be pushing them toward commission-free 529s.

As the cost of higher education continues to rise, more families are socking away money into 529 college savings plans. As of 2015, these accounts held $253.2 billion in assets, according to the College Savings Plans Network.

Earnings grow on a tax-deferred basis in 529 plans, and withdrawals are also tax-free if the money is used for the beneficiary's qualified education expenses.

Not all college savings plans are equal, however. Investors need to be aware of the internal expenses in these plans as well as the commissions advisors may receive for selling 529s. For instance, investors in certain portfolios can shell out an average of 4.75 percent in charges paid upfront to the advisor, according to fund research firm Morningstar.

Considering that the average 529 account had a balance of $20,190 last year, according to the College Savings Plans Network, every dollar spent on these sales charges and fund expenses means less money to pay for college.

As a result, some fee-conscious advisors are recommending that clients use what's known as direct-sold 529 plans, which investors can purchase from most states. Wyoming does not offer a 529 plan, and Washington state offers a prepaid college savings plan.

Across the board, costs are declining in 529 plans.

At the same time, more assets are migrating toward direct-sold plans, motivated in part by advisors who are turning away from being paid on a commission basis to being paid a percentage of assets under management or a flat-dollar fee for service.

"The story on a larger scale is the move from commission-based to advisory models," said Paul Curley, director of college savings research at Strategic Insight, a fund research firm in Boston.

Currently, 29 states and Washington, D.C., offer advisor-sold plans, Curley said.

The chart below shows that, over time, direct-sold 529 plans are taking on more assets than their advisor-sold counterparts.

"What is the advisor being paid for?" is the question investors need to consider when it comes to 529s.

For the most part, assets in 529 plans are invested in age-based portfolios that become more conservative as the child gets closer to college age, according to Morningstar.

Even fee-only and fee-based advisors whose clients go the self-directed 529 route find that many of them stick with these options.

"It's very difficult to design, implement and manage an allocation model that will outperform one of the age-based models," said Roy P. Janse, managing partner at DeHollander & Janse Financial Group in Greenville, South Carolina.

"I see it as a violation of my fiduciary responsibilities to charge someone a 5 percent or 6 percent commission simply for recommending that the investor allocate their money into the appropriate age-based model," he said.

Not all cost-conscious advisors go the self-directed route, however.

Patrick Dougherty, founder of Dougherty Wealth Management in Dallas, operates a fee-only practice and recommends advisor-sold 529s. "Often with self-directed accounts, investors listen to watercooler talk and pick what their friends recommend," he said.

Dougherty uses an institutional share class to keep costs down, and he doesn't charge a commission. "I'm helping them pick the investments, but once I do that, it's on autopilot," he said. The funds he chooses use age-based allocations.

Advisors who aren't receiving commissions for recommending a 529 still provide guidance on how to contribute to the plans and whether there are state-level tax benefits for choosing a given plan.

Instead of operating on a commission, however, they bill the client separately for their time, or they include the 529 guidance as part of the overall financial planning service they already offer for a fee.

"This way it becomes planning-centric," said Valerie L. Chaille, a certified financial planner at Circle City Wealth Advisors in Indianapolis.

"You're looking at the 529 not just from the perspective of saving for college, but how are you helping yourself out from a tax standpoint," she said.

Are you ready for a self-directed 529? Curley of Strategic Insight recommends that you consider the following:

  • Open your eyes to fees: Even if you skip the commissions, be aware of other costs, including annual maintenance fees, fund fees and administration and management expenses.
  • Be aware of the tax incentives: Some states provide their residents tax benefits for choosing that state's 529. Others provide benefits to those who open these accounts, regardless of which state's plan they use.
  • If you need help from an expert, get it: Researching investment options and learning about fees and tax deductions can be overwhelming. "If you think you need help, you probably do," said Curley.