Changes to Illinois tax law may make the state's 529 college savings plan more attractive to Illinois residents, but they could also inspire other states to try to get residents to favor their in-state 529 plans. If that happens, fund companies that have established a 529 footprint in one state may have to scramble to form alliances with multiple states to get them into their plan.

Governor George H. Ryan recently signed a bill that requires Illinois residents to pay taxes on funds withdrawn from out-of-state 529 plans to pay college tuition. Only withdrawals from the Illinois 529 plan, managed by Salomon Smith Barney of New York, are exempt from taxation.

Analysts said that if other states follow Illinois' lead, it could dramatically alter the 529 landscape.

Mark Beeson, president of the Chicago-based Bank One Corp.'s One Group of Funds, which runs Illinois's 529 plan, said this type of legislation is bad news.

"If states limit the tax benefits to their own products, it will limit competition, which could affect pricing and allow poor-performing fund companies to have a monopoly," Beeson said. "This ultimately is bad for the beneficiaries."

Additionally, Illinois' new law will not allow investors to deduct withdrawals from the Bright Start 529 plan if the money is rolled over from an out-of-state plan. Also, assets in the Bright Start plan are not included in a family's income when the state's Financial Aid Board determines if a student is eligible for Illinois-funded financial aid programs, but savings in other states' plans are.

These 529 plans, named for a section of the Internal Revenue Code, have offered federal tax deferments for college savings since 1997. Since Jan. 1 withdrawals for qualified expenses have been exempt from federal taxes, but state tax requirements vary.

Illinois is the first state to impose legislation that exclusively taxes out-of-state plans. California is the only state that currently taxes all 529 withdrawals.

Mutual fund and banking analysts said the law not only makes it more difficult for out-of-state 529 providers to sell their products in Illinois, but it could also encourage other states to create similar restrictions.

"This is a sign of the protectionism that is becoming more common [among] states and their 529 plans," said Joseph F. Hurley, CEO of of Pittsford, N.Y.

"There are many states looking at making changes to laws or to programs to prevent residents from taking tax benefits when their money is invested out of state," he said.

States have been competing for 529 plan assets since the first plans were created, but by "using and abusing state tax law more vigorously, we could see greater competition," Hurley said.

Taking a Cue from the Feds

Doug Neilson, director of marketing for the College Savings Plans of Maryland, said that until this year every state except New Jersey taxed college savings plans. Most of the other states stopped taxing 529 earnings when the plans were exempted from federal taxes, he said.

Because of the Illinois law, Neilson predicts that more state legislators will look to tax out-of-state plans. Similar legislation has been already proposed in Maryland, he noted.

However, "this is an industry in its infancy, and this is a bump in the road," Neilson said. "We are still in the process of evolving, and this is part of that evolution."

In May, the Maryland General Assembly passed a bill that would have had the opposite effect of the Illinois law by allowing taxpayers to deduct earnings from out-of-state plans. Governor Parris Glendening vetoed the bill after Baltimore-based T. Rowe Price, which manages Maryland's plan, lobbied against it.

Jonathan H. Randall, manager of nonmanufactured products for PNC Financial Services Group of Pittsburgh, said that to successfully market 529s, a company must be able to sell the plans in all the states where it does business.

PNC sells plans created by Fidelity Investments and Putnam Investments, both of Boston, as well as by American Funds of Los Angeles and Manulife of New York. When Delaware Investments of Philadelphia unveils the Pennsylvania College Savings Plan in the fall, PNC will look to sell it, too, Randall said.

"At the end of the day, you have to provide products from multiple providers in order to sufficiently supply your customers with the right product," he said. "For now, especially as the 529 product is new and still being legislated, we have to offer an even wider set of products." Randall said.

Neilson maintained that even though the legislation may initially hurt national distribution, investors will continue to consider out-of-state plans.

"Changing income tax status may make plans more attractive on the surface, but investors and advisers look deeper than that," he said. "Investors are going to look at the in-state plan first. They are going to consider tax issues, but they also have to consider the structure of the plan. Is it load or no-load? Does it have an enrollment fee?" These are important considerations, he said.

"Just because Illinois offers attractive tax incentives doesn't mean another plan might be more attractive," he said.

According to Randall, fund companies will have to wait and see what the future holds for 529 plans.

"I hope that this is not a trend, but right now there is really no way of knowing," he said. "For now we don't know if this will be the norm. I think what we have to do is offer as many products as we can. There is certainly no way that offering more could be a bad thing for our customers down the road."

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