All 529 plans are operated by state governments and educational institutions. How to choose one? This post explains how, from financial aid expert Mark Kantrowitz, senior vice president and publisher of Edvisors.com, a free web site about planning and paying for college. He is the author of several bestselling books about scholarships and financial aid, including “Filing the FAFSA (2015-2016 Edition)” and “Secrets to Winning a Scholarship.” Dozens of tip sheets about paying for college are available for free download at www.edvisors.com/ask/tips, including a one-page tip sheet about saving for college.
By Mark Kantrowitz
Families are faced with many options for choosing a 529 college savings plan. They can invest in any state’s 529 plan, not just their own state’s plan. Most states offer direct-sold and advisor-sold plans. Within each 529 plan, there are numerous investment options.
The first step is to focus on fees. Minimizing costs is the key to maximizing net returns. If the investment offers a 6 percent average annual rate of return, but charges 2 percent in annual fees, the fees will consume a third of the investment returns. In some state 529 plans, the fees exceed the tax savings, meaning that the investor would be better off saving for college in a taxable account.
Generally, investors should look for 529 plans with fees that are less than 0.5 percent. This will preserve more of the returns to help the investment grow. State 529 plans run by Vanguard, Fidelity and TIAA-CREF often have the lowest fees.
Investors should prefer the direct-sold version of a state’s 529 college savings plan over the adviser-sold version. Although adviser-sold plans may have better investment returns, due to active management, they also have much higher fees. The net return on investment, after subtracting the fees, is almost always lower than the direct-sold plans. Also, investment advisers have a tendency to steer investors toward 529 plans that offer the adviser the highest commission, not the lowest cost or best tax benefits. (Note that seven states – DC, LA, NJ, RI, SC, SD and WV – offer the direct-sold version only to state residents.)
State income-tax benefits, however, offer another potential source of savings. More than two-thirds of the states provide a state income tax deduction or credit on contributions to the state’s 529 plan. (Six states offer tax parity, where the tax deduction is based on contributions to any state’s 529 plan.) So, investors should always consider their own state’s 529 plan first.
However, fees are charged annually on the full asset value of the 529 plan while state income-tax benefits are based on just that year’s contributions. Thus, it is more important to focus on fees when the child is young and state income-tax benefits when college is just a few years away. If the product of the difference in fees with the number of years until college matriculation is greater than the taxpayer’s marginal state income tax rate, the plan with the lower fees will yield a greater net return on investment. For example, if the family lives in a state where the state’s 529 plan charges 1.5 percent in fees and offers a state income-tax deduction on contributions and the state income-tax rate is 3 percent, the family should choose a state 529 plan with 0.5 percent in fees when there are three or more years left until the student enrolls in college.
Within the 529 plan, choose an age-based asset allocation to balance risk with return. During any 17-year period, the stock market will drop by at least 10 percent two or three times. In 2008, the stock market dropped by nearly 40 percent. An age-based asset allocation manages this risk by starting offer with an aggressive mix of investments when the child is young and shifts it to a more conservative mix of investments as college approaches. When the child is young, less money is at risk and there is more time to recover from losses. As college approaches, the 529 plan assets should be shifted to a mix of investments where there is less risk of loss to principal.
Additional insights are available at www.edvisors.com/plan-for-college/saving-for-college/. Morningstar.com and Savingforcollege.com offer detailed plan ratings.