What Is a 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to help pay for education. Originally limited to postsecondary education costs, it was expanded to cover K-12 education in 2017 and apprenticeship programs in 2019.

The two major types of 529 plans are education savings plans and prepaid tuition plans.

Education savings plans grow tax-deferred, and withdrawals are tax-free if they’re used for qualified education expenses. Prepaid tuition plans allow the account owner to pay current tuition rates for future attendance at designated colleges and universities. That means that, most likely, you can lock in a lower cost of college attendance.

529 plans are also referred to as qualified tuition programs and Section 529 plans.

Understanding 529 Plans

Although 529 plans take their name from Section 529 of the federal tax code, the plans themselves are administered by the 50 states and the District of Columbia.

Anyone can open a 529 account, but they are typically established by parents or grandparents on behalf of a child or grandchild, who is the account’s beneficiary.

In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.

The money in a 529 plan grows on a tax-deferred basis until it is withdrawn. What’s more, as long as the money is used for qualified education expenses as defined by the IRS, those withdrawals aren’t subject to either state or federal taxes. In addition, some states may offer tax deductions on contributions.

In the case of K-12 students, tax-free withdrawals are limited to $10,000 per year.

Since tax benefits vary depending on the state, it’s important that you check the details of any 529 plan to understand the specific tax benefits that you may or may not be entitled to.

Types of 529 Plans

The two main types of 529 plans have some significant differences.

Education Savings Plans

529 savings plans are the more common type. The account holder contributes money to the plan. That money is invested in a pre-set selection of investment options.

Account-holders can choose the investment (usually mutual funds) that they want to invest in. How those investments perform will determine how much the account value grows over time.

Many 529 plans offer target-date funds, which adjust their assets as the years go by, becoming more conservative as the beneficiary gets closer to college age.

Withdrawals from a 529 savings plan can be used for both college and K-12 qualified expenses. Qualified expenses include tuition, fees, room and board, and related costs.

The SECURE Act of 2019 expanded tax-free 529 plan withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for both account beneficiaries and their siblings.

And the SECURE Act of 2022, passed as part of the 2023 Omnibus funding bill, will permit rolling over up to $35,000 of unspent funds in a 529 account into a Roth IRA account, starting on Jan. 1, 2024. To qualify, the account must be at least 15 years old,

Prepaid Tuition Plans

Prepaid tuition plans are offered by a limited number of states and some higher education institutions. They vary in their specifics, but the general principle is that they allow you to lock in tuition at current rates for a student who may not be attending college for years to come. Prepaid plans are not available for K-12 education.

As with 529 savings plans, prepaid tuition plans grow in value over time. Eventual withdrawals from the account used to pay tuition are not taxable. However, unlike savings plans, prepaid tuition plans do not cover the costs of room and board.

Prepaid tuition plans may place a restriction on which colleges they may be used for. The money in a savings plan, by contrast, can be used at almost any eligible institution.

In addition, the money paid into a prepaid tuition plan isn’t guaranteed by the federal government and may not be guaranteed by some states. Be sure you understand all aspects of the prepaid tuition plan.

Tax Advantages of 529 Plans

Withdrawals from a 529 plan are exempt from federal and state income taxes, provided the money is used for qualified educational expenses.

Any other withdrawals are subject to taxes plus a 10% penalty, with exceptions for certain circumstances, such as death or disability.

The money you contribute to a 529 plan isn’t tax deductible for federal income tax purposes. However, more than 30 states provide tax deductions or credits of varying amounts for contributions to a 529 plan.

In general, you’ll need to invest in your home state’s plan if you want a state tax deduction or credit. If you’re willing to forgo a tax break, some states will allow you to invest in their plans as a nonresident.

Advantages and Disadvantages of 529 Plans

What Is an Agency Problem?

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

Understanding Agency Problems

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, the plumber may make three times as much money by recommending a service the agent does not need. An incentive (three times the pay) is present, causing the agency problem to arise.

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal’s or client’s best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court’s assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

Minimizing Risks Associated With the Agency Problem

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.

Regulations

Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients’ interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client’s best interest.

Incentives

The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal’s best interests. For example, a manager can be motivated to act in the shareholders’ best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing, or the threat of takeovers.

Principals who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders’ and the CEO’s interests would be aligned and benefit from the rise in stock price.

Principals can also alter the structure of an agent’s compensation. If, for example, an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.

Real-World Example of an Agency Problem

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. The company’s executives used fraudulent accounting methods to hide debt in Enron’s subsidiaries and overstate revenue. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings.

In the four years leading up to Enron’s bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets. Although Enron’s management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.

What Is an American Depositary Receipt (ADR)?

The term American depositary receipt (ADR) refers to a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares—usually one share—of a foreign company’s stock. The ADR trades on U.S. stock markets as any domestic shares would.

ADRs offer U.S. investors a way to purchase stock in overseas companies that would not otherwise be available. Foreign firms also benefit, as ADRs enable them to attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges.

How American Depositary Receipts (ADRs) Work

American depositary receipts are denominated in U.S. dollars. The underlying security is held by a U.S. financial institution, often by an overseas branch. These securities are priced and traded in dollars and cleared through U.S. settlement systems.

In order to begin offering ADRs, a U.S. bank must purchase shares on a foreign exchange. The bank holds the stock as inventory and issues an ADR for domestic trading. ADRs list on either the New York Stock Exchange (NYSE) or the Nasdaq, but they are also sold over-the-counter (OTC).

U.S. banks require that foreign companies provide them with detailed financial information. This requirement makes it easier for American investors to assess a company’s financial health.

Types of American Depositary Receipts

American depositary receipts come in two basic categories:

Sponsored ADRs

A bank issues a sponsored ADR on behalf of the foreign company. The bank and the business enter into a legal arrangement. The foreign company usually pays the costs of issuing an ADR and retains control over it, while the bank handles the transactions with investors. Sponsored ADRs are categorized by what degree the foreign company complies with Securities and Exchange Commission (SEC) regulations and American accounting procedures.

Unsponsored ADRs

A bank also issues an unsponsored ADR. However, this certificate has no direct involvement, participation, or even permission from the foreign company. Theoretically, there could be several unsponsored ADRs for the same foreign company, issued by different U.S. banks. These different offerings may also offer varying dividends. With sponsored programs, there is only one ADR, issued by the bank working with the foreign company.

One primary difference between the two types of ADRs is where they trade. All except the lowest level of sponsored ADRs register with the SEC and trade on major U.S. stock exchanges. Unsponsored ADRs will trade only over the counter. Unsponsored ADRs never include voting rights.

ADR Levels

ADRs are additionally categorized into three levels, depending on the extent to which the foreign company has accessed the U.S. markets.

Level I

This is the most basic type of ADR where foreign companies either don’t qualify or don’t want to have their ADR listed on an exchange. This type of ADR can be used to establish a trading presence but not to raise capital.

Level I ADRs found only on the over-the-counter market have the loosest requirements from the Securities and Exchange Commission (SEC) and they are typically highly speculative. While they are riskier for investors than other types of ADRs, they are an easy and inexpensive way for a foreign company to gauge the level of U.S. investor interest in its securities.

Level II

As with Level I ADRs, Level II ADRs can be used to establish a trading presence on a stock exchange, and they can’t be used to raise capital. Level II ADRs have slightly more requirements from the SEC than do Level I ADRs, but they get higher visibility and trading volume. 

Level III

Level III ADRs are the most prestigious. With these, an issuer floats a public offering of ADRs on a U.S. exchange. They can be used to establish a substantial trading presence in the U.S. financial markets and raise capital for the foreign issuer. Issuers are subject to full reporting with the SEC.

American Depositary Receipt Pricing and Costs

An ADR may represent the underlying shares on a one-for-one basis, a fraction of a share, or multiple shares of the underlying company. The depositary bank will set the ratio of U.S. ADRs per home-country share at a value that they feel will appeal to investors. If an ADR’s value is too high, it may deter some investors. Conversely, if it is too low, investors may think the underlying securities resemble riskier penny stocks.

Because of arbitrage, an ADR’s price closely tracks that of the company’s stock on its home exchange. Remember that arbitrage is buying and selling the same asset at the same time in different markets. This allows traders to profit from any differences in the asset’s listed price. 

ADR Fees

Investing in an ADR may incur additional fees that are not charged for domestic stocks. The depositary bank that holds the underlying stock may charge a fee, known as a custody fee, to cover the cost of creating and issuing an ADR.

This fee will be outlined in the ADR prospectus, and typically ranges from one to three cents per share. The fee will be either deducted from dividends, or passed on to the investor’s brokerage firm.

ADRs and Taxes

Holders of ADRs realize any dividends and capital gains in U.S. dollars. However, dividend payments are net of currency conversion expenses and foreign taxes. Usually, the bank automatically withholds the necessary amount to cover expenses and foreign taxes.

Since this is the practice, American investors would need to seek a credit from the IRS or a refund from the foreign government’s taxing authority to avoid double taxation on any capital gains realized.

Those interested in learning more about ADRs and other financial topics may want to consider enrolling in one of the best investing courses currently available.

Advantages and Disadvantages of American Depositary Receipts

As with any investment, there are distinct advantages and disadvantages of investing in ADRs. We’ve listed some of the main ones below.

Advantages

As noted above, ADRs are just like stocks. This means they trade on a stock exchange or over the counter, making them fairly easy to access and trade. Investors can also easily track their performance by reviewing market data.

Purchasing ADRs is easy because they’re available directly through American brokers. This eliminates the need to go through foreign channels to buy stock in a company in which you may be interested. Since they’re available domestically, shares are denominated in U.S. dollars. But that doesn’t mean you avoid any direct risks associated with fluctuations in currency rates.

One of the most obvious benefits of investing in ADRs is that they provide investors with a way to diversify their portfolios. Investing in international securities allows you to open your investment portfolio up to greater rewards (along with the risks).

Disadvantages

The main problems associated with ADRs are that they may involve double taxation—locally and abroad—and how many companies are listed. Unlike domestic companies, there are a limited number of foreign entities whose ADRs are listed for the public to trade.

As noted above, some ADRs may not comply with SEC regulations. These are called unsponsored ADRs, which have no direct involvement by the company. In fact, some companies may not even provide permission to list their shares this way.

Although investors can avoid any of the direct risks that come with currency exchange, they may incur currency conversion fees when they invest in ADRs. These fees are established in order to directly link the foreign security and the one traded on the domestic market.

History of American Depositary Receipts

Before American depositary receipts were introduced in the 1920s, American investors who wanted shares of a non-U.S. listed company could only do so on international exchanges—an unrealistic option for the average person back then.

While easier in the contemporary digital age, there are still drawbacks to purchasing shares on international exchanges. One particularly daunting roadblock is currency exchange issues. Another important drawback is the regulatory differences between U.S. and foreign exchanges.

Before investing in an internationally traded company, U.S. investors have to familiarize themselves with the different financial authority’s regulations, or they could risk misunderstanding important information, such as the company’s financials. They might also need to set up a foreign account, as not all domestic brokers can trade internationally.

ADRs were developed because of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. J.P. Morgan’s (JPM) predecessor firm Guaranty Trust pioneered the ADR concept. In 1927, it created and launched the first ADR, enabling U.S. investors to buy shares of famous British retailer Selfridges and helping the luxury depart store tap into global markets. The ADR was listed on the New York Curb Exchange.

A few years later, in 1931, the bank introduced the first sponsored ADR for British music company Electrical & Musical Industries (also known as EMI), the eventual home of the Beatles. Today, J.P. Morgan and BNY Mellon, another U.S. bank, continue to be actively involved in the ADR markets.

Real-World Example of ADRs

Between 1988 and 2018, German car manufacturer Volkswagen AG traded OTC in the U.S. as a sponsored ADR under the ticker VLKAY. In August 2018, Volkswagen terminated its ADR program. The next day, J.P. Morgan established an unsponsored ADR for Volkswagen, now trading under the ticker VWAGY.

Investors who held the old VLKAY ADRs had the option of cashing out, exchanging the ADRs for actual shares of Volkswagen stock—trading on German exchanges—or exchanging them for the new VWAGY ADRs.

The Bottom Line

American Depositary Receipts, or ADRs, allow Americans to invest in foreign companies. Although these companies do not ordinarily trade on the U.S. stock market, an ADR allows an investor to buy these stocks as easily as they would invest in any domestic stock. The arrangement also benefits foreign firms, allowing them to raise capital from the U.S. market.

Correction—Jan. 24, 2023: A previous version of this article wrongly stated that foreign currency exchange rate fluctuations do not affect the price of ADR and therefore ADR holders avoid any direct risks associated with fluctuations in currency rates. Actually, ADR have exchange rate risk and the price of an ADR is affected by the movements of both the company’s local share price and the national currency rate of exchange against the U.S. dollar.