Anne Marie Etergino is not using 529 college savings plans to pay for her two children's college tuition. This may not sound like a big deal until you learn that she is a senior vice president at RBC Wealth Management in Chevy Chase, Md., and is more than aware of the tax benefits of using these plans. It gets more interesting when you learn that she is putting her kids through two of the most expensive colleges in the United States—Georgetown University and Wake Forest College. Instead, she saved for her kids' college by investing in non-tax-advantaged mutual funds.

If you believe all the marketing material put out by large 529 plan managers like UPromise, Etergino missed a golden financial opportunity, one of which every family in America with kids should take advantage. Why didn't she sign up to get tax-free growth on the undoubtedly very large sum of money needed to pay for these schools?

Because for people who, like Etergino, are in a position where they either don't want, or can't afford, to tie up an enormous portion of their liquid assets, 529s just don't make sense, she says. "I'm in a high-risk business. I wanted an investment that was conservative enough for me and that would be flexible enough that my money would be available for my purposes," says Etergino, who has over $550 million in assets under management.

Although Etergino didn't feel a 529 suited her needs, she suggests them frequently for her clients (who average over $5 million in investable assets) for a very specific purpose—as an estate planning vehicle. The tax benefits that can be gained from their aggressive use makes them the perfect vehicle for high-net-worth clients, the type of people who don't need much help saving for their children's college education.

"These plans are great for grandparents," Etergino says, "because they can remove a considerable amount of money from their estate while still leaving [them] in control of the assets." The IRS currently allows investors to contribute up to $14,000 per year, the 2013 gift tax exclusion limit, to a beneficiary in a 529. It also allows four more forward-year contributions to that beneficiary, for a total of $70,000 per taxpayer, or $140,000 per couple. Such contributions can be repeated five years later with the only limits being those set by each state, many of which cap contributions to any single beneficiary at $300,000 (even this cap can be avoided by contributing to another state's 529 plan, too). For grandparents with six grandchildren, that's a gift-tax-free $840,000 transfer out of the estate in just five years—and not one penny applies to their lifetime gift tax exemption amount ($5.25 million in 2013).

One of Etergino's clients has used 529s extensively to fund education for all his grandchildren, to the tune of $60,000 to each account. In five years, at today's higher gift-tax exclusion of $14,000 per year, he will put $70,000 more in each account. Ertegino says this client also paid for private school for each of his grandchildren (tuition paid directly to a school is not considered a federally taxable gift), so clearly the tax-free nature of the plans' income wasn't his motivating factor in setting up the plans. Instead, he used 529s as a tool to move a lot of cash out of his estate, lowering his total future estate taxes and avoiding gift taxes in the process.

Not the Original Plan
This tax planning strategy was likely the last purpose envisioned by the federal legislators who created the original tax-advantaged 529 plans back in 1996 and bolstered their use in 2001, when Congress passed legislation that allowed all income earned within the plans—which are funded with after-tax money—to be withdrawn tax-free if applied to education expenses. The stated goal was to boost the use of the plans by families who needed the most help paying for college.

A December study by the U.S. Government Accountability Office shows the stark contrast between Congress's original intent and the reality of the modern 529 plan. The median annual income of families invested in 529s is three times higher—$142,000—than that of families who do not use them. In addition, 47% of families with 529s have income over $150,000. Only 8% of families without 529s have the same level of income. Some would argue that this is logical, since families with smaller incomes and lower levels of assets may be prioritizing other financial needs, like retirement, over college savings. Still, anecdotal evidence from advisors implies that for the very wealthy, 529s are less a savings plan than a vital tax planning tool that has the nice side benefit of paying for a child's education with tax-free gains.

James Rimmel, a senior wealth manager at the Pittsburgh office of UBS, had a client, an 80-year-old woman with terminal cancer, who was given a year to live. She needed to get her estate down below inheritance tax thresholds, but without running afoul of gift taxes. She had five kids and 20 grandchildren, and with Rimmel's guidance, she made gifts to all the children and grandchildren and set up 529s for each grandchild. She funded the 529s at the annual maximum, then did it again five months later on Jan. 2 of the following year. When she died, her estate taxes were $264,000 lower than they would have been without the strategy.

In addition, although many plans require that the money be spent by the time the beneficiary reaches age 30, there are no tax consequences if you change the designated beneficiary to another member of the family. Also, funds may be distributed tax-free from a 529 plan if they are rolled over to another plan for the benefit of the same beneficiary or for the benefit of a member of the beneficiary's family. So, for example, you can roll funds from the 529 for one of your children into a sibling's plan or into a plan for the beneficiary's spouse, without penalty. There is also a once-a-year limit to reallocating funds in a 529, but this limitation can be avoided if the account owner moves the funds from one state's 529 plan to another state's plan one time within a 12-month period for the same beneficiary.

Use Is Up
This may be a key reason why use of 529s is surging. A total of $168.5 billion was invested in 529 plans at the end of 2012, up 17% from a year earlier, according to the Financial Research Corp. About half that increase was due to new money flowing to funds, the other half to increased market value of fund assets, according to a Morningstar report from April 2013.

However, last year, for the first time since 529s were introduced, direct-sold plans held more assets than advisor-sold plans, according to the Morningstar report. This doesn't mean that advisors aren't recommending them to their clients, says Morningstar analyst Laura Lutton. She thinks it could have more to do with the shift of many advisors to an RIA model, in which clients would purchase a direct-sold 529. Meanwhile, she says, advisor-sold plans tend to have significantly higher balances and are being used by clients "in a more strategic way."

For advisors, the 529 plans may not be a massive revenue generator, but they are a must in a toolbox of client services. "I would say my 529 business is not a significant source of my revenue, though it may be for some people," says advisor Richard Wright, a senior vice president for investments at Wedbush Securities in San Diego, Calif. "But it is important as a key service to good clients. You're servicing the relationship."

At the same time, he says that the 529 plans can be labor intensive. "They get confusing with all the bells and whistles, which keep getting added or changed," he says. For example, states will change fund managers or add different investment options. State tax deductions are frequently changed. "As an advisor you have to keep up to date. Lots of times you have to go to school on them to keep informed," he says.

In addition to keeping up with the ever-changing tax rules and manager changes, advisors will be challenged when selecting the best plan for their clients. Wealthy clients still want to show a healthy return on their investments, even if the primary motivation is tax planning.

Morningstar analyst Kailin Liu points out that in addition to their complexity, 529s have internal "program management fees" for funds within funds and state administration fees, which taken together can range from about 0.15% to 0.35%. The average of the two fees for 529s is about 0.2% to 0.25%, and they "create a hurdle," she says, that the plans have to exceed in their performance levels in order to match the performance of corresponding non-529 mutual fund-type investments. Morningstar's latest report, titled The2013 529 College-Savings Plans Industry Survey, also states that "even though 529 plans' investment options have improved considerably in the past several years, 529 options' average performance has lagged that of mutual funds."

Nonetheless, recent growth rates indicate that the tax benefits have trumped performance concerns among investors, with Virginia's CollegeAmerica 529 becoming the industry-wide favorite advisor-sold plan. Rimmel at UBS likes that it is run by America Funds, "features low fees and has a style that is a little less volatile than many other funds," he says.

Morningstar rates 529s by examining five factors: the program managers; the state treasurer or private consultant that runs the plan; the selection process for assets; the expense ratio and internal fees; and past performance. The final Morningstar rating-gold, silver, bronze, neutral and negative-is based on analyzing those five factors, Liu says.

In its latest analyst report, Morningstar says it expects all 27 of its positively-rated 529 plans "to outperform on a risk-adjusted basis after tax benefits over a full market cycle," Liu adds. Even neutral plans, Liu says, can be okay. Only a handful of plans-four this year-are negatively rated and should probably be avoided, she says. These plans, two offered by Rhode Island and one each by Minnesota and Kansas, typically had stewardship-related problems, she says. Only one, the Rhode Island College Bound Fund, was advisor-sold.

Virginia's CollegeAmerica 529 plan gets a silver rating, making it the highest-rated advisor-sold plan on the Morningstar list. (All the gold-rated plans are sold direct.) Advisors had invested $35.5 billion into that fund on behalf of clients by the end of 2012, which represented slightly more than a fifth of the total amount invested in all 529s, advisor- or direct-sold, combined.

Aside from selecting a plan that meets clients' performance expectations, advisors must also investigate the various tax advantages and matching contribution options offered by some states to in-state investors. For Allan Strange, executive vice president of investments at Janney Montgomery Scott in Richmond, Va., that decision is easy. Virginia, he points out, gives its residents up to $4,000 in income tax deductions for contributions made to its state-run 529 plan.

Most tax deductions for investing in home-state 529 plans are limited. In New York State, deductions are capped at $5,000, and at $10,000 in Oklahoma. States that offer tax credits, like Indiana, or that match contributions, like North Dakota, also limit their size, and only allow one such benefit per 529 plan per taxpayer per year, regardless of the number of plans funded. These limits make a home-state offering most attractive for those making smaller contributions. On the other hand, there's very little downside to ignoring the home-state plan for those investing a large amount in a 529 for estate planning purposes, says Daniel Sherman, family wealth director at Morgan Stanley Wealth Management's Sherman Group in New York.

Once the home-state option has been evaluated, the style of the 529 plan is also a key factor in selecting a good vehicle for wealthy clients. Grant Ingram, a senior vice president of investments with Benjamin Edwards in Kansas City, Kan., likes the target-date option, which has grown increasingly popular as a 529 plan feature. "That target-date option has taken a lot of the guesswork out of these plans," he says. (Ingram doesn't like the Kansas 529 offerings, which he says have high internal fees, but he says the plan offered by neighboring Missouri, where many of his clients live, is good and has been "getting a lot better.")

That said, not everyone agrees with the idea of choosing a pre-set glide path for college funds. "The glide paths are pretty conservative," RBC's Etergino says. "I would hope that advisors wouldn't choose these, especially if the balance is substantial."

What About Everyone Else?
For wealthy clients concerned with minimizing their estates while preserving wealth, 529s are increasingly a no-brainer planning tool. But for advisors working with mass-affluent clients, or clients with even smaller incomes and portfolios—the very people for whom the 529s were created—the question of whether to use a 529 plan becomes more tactical and philosophical.

First, the advisor needs to establish whether the client has even saved enough for retirement. "If you are having trouble saving for retirement, you should not be paying for a 529 plan," says Sherman of Morgan Stanley. A study in March 2013 by the Employee Benefit Research Institute found 57% of U.S. workers have less than $25,000 in total household savings and investments, excluding their homes. Given the strong predictions that most Americans will not have sufficient retirement savings when the time comes, 529s may be right for only a small portion of the general population.

Even if they are amassing adequate retirement savings, middle-income families should moderate their 529 investments, advises Etergino. "For clients who can afford to fully fund a 529 plan, we still recommend against it." Instead, Etergino and her team suggest only funding 50% of estimated college costs, because clients "can't know what the future holds. Maybe your child will want to go to your state university, or will win an athletic or a merit scholarship."

There are other good reasons to be wary of 529s for non-wealthy families. Unlike 401(k) assets, all 529 savings in a family—regardless of the named beneficiary—are counted as assets available to pay for the first child on the Free Application for Federal Student Aid (FAFSA) form used by all public colleges in calculating need-based financial aid. Private colleges that use the Parent Profile form instead of FAFSA even require parents to list grandparent-owned 529 plans if the beneficiary is applying for aid.

In addition, for families who are using 529s to fund college and not for estate planning, Etergino is turned off by the higher fees usually charged by state plans. Morningstar reports that information can be harder to ferret out about 529 fees than about fees for SEC-regulated mutual funds. (State-sponsored 529 plans are regulated by the Municipal Securities Rulemaking Board, which provides less disclosure than the SEC.)

Of course, the biggest risk for people with moderate income who save for their children's college costs with a 529 plan is that the money doesn't get used at all. This could happen, for example, if the child decides on a less pricey state school instead of an anticipated private college or opts not to go to college. At that point, the money is stuck in the 529 plan. It either has to be reassigned to another family member as beneficiary (as outlined above) or liquidated, with the owner paying a 10% penalty on any earnings (although not the principal) and state and federal income taxes on the gain.

Again, despite the challenges, advisors serving clients with a mix of income levels see 529s as a staple item in the advisory arsenal that still gets the job done for families that are using them as a tax-advantaged way to save for college, as long as the potentially negative impacts of their use for lower-income clients are carefully considered and mitigated. "We don't like people to over-fund them," says Teri Hollander Albin, an advisor at the Evanston, Ill., branch of Hilliard Lyons, "but if people do invest $5,000 a year, it gets them farther along the path toward funding their children's college costs."

The potential market for these plans is vast and largely untapped, despite aggressive marketing by plans like UPromise Investments, a fund manager that operates 11 state plans and that, with its UPromise savings affiliate, engages in promotions with businesses like supermarkets and with trade unions. And despite the growth in the use of these plans, there is plenty of upside for advisors looking to offer them to clients. A 2013 study by market research firm Ipsos and Sallie Mae found that 55% of parents had never heard of 529 plans. Even among college savers in the study, 50% said they hadn't heard of them.

States and some of the private firms managing 529 plans may be pushing them too hard—perhaps inappropriately—to lower-income families who aren't even able to save enough for retirement or who don't fully understand the potentially negative consequences that come with the plans. For advisors, however, 529s are proving to be a valuable tool for those with the financial assets to be able to take advantage of them, both as a way of paying for college with tax-free gains and as a way of mitigating gift and estate taxes.