NASD announced recently that it had ordered Minneapolis-based Ameriprise Financial, formerly American Express Financial Advisors, to pay a fine of $500,000 for failing to adequately supervise the firm’s sales of Section 529 college savings plans.

In addition NASD, the private-sector regulator of the securities industry, also ordered the firm to pay about $750,000 to compensate more than 500 customers whose accounts were “disadvantaged by those supervisory failures.”

So why exactly was Ameriprise fined? First, you have to understand what a 529 plan is and why it pays to know whether your state provides a tax-advantaged reason to sign up with its plan.

Type of plans

There actually are two types of 529 plans: prepaid tuition plans and savings plans. A prepaid tuition plan allows people to essentially prepay for tuition, locking in the cost at today’s prices. The more popular savings plan allows people to invest in a tax-free investment account.

When you invest in a 529 savings plan your contributions grow tax free and distributions are free from federal taxes as long as the money is used to pay for qualified higher education expenses. Every state and the District of Columbia now offers at least one 529 plan.

Although the 529 plans are sponsored by states, you can invest in any plan regardless of where you live. For instance, if you live in California you can invest in a 529 plan in Illinois or Wisconsin if you like.

But there’s a bonus for residents living in the 26 states and the District of Columbia that offer varying state tax incentives, NASD points out. For example, if you invest in New York State’s 529 savings plan you can get a state income tax deduction of up to $5,000 ($10,000 for married couples filing jointly) if you are a New York resident. Maryland residents can get up to a $2,500 state tax break each year for each 529 savings account they have.

So if you’re thinking about investing in a 529 savings plan, you should always check to see if your home state offers a tax break. This doesn’t mean you should only invest in that plan. It might turn out that the tax break isn’t worth it when compared with the high expenses or poor performance of your state’s savings plan.

Lack of information

Still, investors ought to be told about the benefit, and it was a failure of Ameriprise to properly advise customers of state tax breaks that riled the NASD.

During the period of May 2001 through October 2003, approximately half of the states offered tax benefits to residents who purchased an in-state plan. During the same period, however, NASD found that Ameriprise offered and sold only one 529 plan – a plan sponsored by the state of Wisconsin.

How could that one plan be appropriate for all their customers?

Well, NASD didn’t think it was.

Approximately 32 percent of Ameriprise’s sales – more than $200 million – were to customers who lived in one of the tax-advantaged 529-plan states.

Investors in five of those states (New Mexico, South Carolina, Illinois, Colorado and West Virginia) could have received unlimited state income tax deductions for investments in their home state’s 529 plans.

NASD said Ameriprise didn’t have adequate procedures in place to take state income tax benefits into account when determining the suitability of 529 sales to its customers.

In settling with NASD, Ameriprise neither admitted nor denied the allegations.

“We are pleased to have resolved this matter and we have modified our procedures with respect to 529 plans,” said David Kanihan, a spokesman for Ameriprise. The company now sells nine 529 plans.

Raise questions

There are two ways that college savings plans are sold to investors – through an investment adviser, brokerage firm or bank, or directly from the state-sponsored plan. Ask about commissions and sales loads before you buy.

Broker- and adviser-sold plans often contain sales loads and higher fees and expenses than direct-sold plans, according to NASD.

When investing in these college-financing investment accounts, keep in mind that even if you have a financial adviser or broker recommending a particular plan, double check his or her advice by doing your own research.

There are a number of online tools to help you. Go to www.savingforcollege.com, an objective source of information about 529 savings plans. Try www.collegesavings.org, run by the College Savings Plans Network. NASD has an excellent section on its Web site about investing for college. The section includes a 529 plan expense analyzer to help you compare fees and expenses. Go to www.nasd.com and click on the link for “Investor Information.” Then click on the link for “College Savings Center.”

I hope other companies will take notice of what happened to Ameriprise. After all, it’s hard enough for families to save for their children’s college education. They certainly deserve to get the best advice possible on where to invest that money.