Getting Started in 529 Plans
Consider these three key questions before taking the plunge.
Because there's no obligation to enroll in the plan or plans your home state provides, 529 investors have myriad investment options. That, of course, is both a blessing and a curse.
On the one hand, a competitive playing field benefits plan participants, eventually leading (one hopes) to lower expenses and better investment products. On the other, with so many options, feeling confident about the choice you make means plowing through reams of scintillating prospectuses and--ugh--doing your homework.
The good news is, we've already done a fair amount of that for you. Click here for a list of 529 plans that you can sort according to criteria, such as fees and expenses and state-tax information. And read below for a brief guide to three of the major issues you should consider before taking the plunge.
You'll still need to do the research to make sure the plan you choose suits your needs and those of your beneficiary, of course. But the information and resources below should help bring the factors that matter most into sharper focus.
How much will I have to pay?
To put it charitably, the cost structure of the typical 529 plan is complicated. In addition to the fees you'll pay for the underlying mutual funds, for example, you'll also encounter costs for management expenses and the mysterious "account maintenance" fee. To add to the confusion, some plans list management fees and expense ratios separately, while others combine them in a single number. Moreover, as you're shopping around, you'll likely encounter a broad array of differently priced share classes, and if you purchase plan shares through a broker-dealer, you can expect to pay an up-front sales charge, or "load," too.
Here are some rules of thumb regarding expenses:
In general, you should expect account-maintenance fees to be waived once your balance reaches a predefined minimum or if you agree to make automatic deposits. Management fees are tougher to shake but, on average, should shave no more than 70 basis points off returns. And paying a load makes sense only if you need financial advice. That said, some plans are only available through broker-dealers. If you choose one of these, you'll have to pay for the advice whether you want it or not.
Our best advice, however, is simply not to get lost in the complicated maze of plan costs. Instead, bear in mind that the fees charged by industry-leading, low-cost providers (such as TIAA-CREF and Vanguard) for the plans they administer rarely top 1% of assets in total. Use that as your benchmark. Plans that charge more may be too expensive. Those that charge less warrant closer consideration.
After all, the performance of the plans' funds will almost certainly be variable, but high expenses represent a consistent drag on returns that will erode gains over time. In other words, the old adage "you get what you pay for" still applies when it comes to 529 investing -- it just applies in reverse.
What am I paying for?
At bottom, most 529 plans are simply tax-favored collections of underlying mutual funds, and, therefore, only as good as the funds they invest in. But what constitutes a good mutual fund? Morningstar's list of 529 plans can be sorted according to the number of underlying offerings that have earned 4 or 5 stars, and that's a fine starting point for your research. Remember, though, that the star rating is a backward-looking measure. In order to get an educated sense of how the funds may perform in the future, you should consider other factors such as the strategies they pursue, how assets are allocated, and, especially, managerial tenure. A fund's impressive star rating may belong predominantly to another team, after all.
Morningstar.com’s Quicktake Report pages can give you the rundown on a fund’s management team, including how long they've been in charge. The quality of the shop behind the funds is also key, however. Generally speaking, asset-management firms with deep analytical resources and a history of retaining top talent earn high marks. There's no Good Housekeeping Seal of Approval for them, unfortunately, but our Fund Family Reports provide useful overviews of four major shops. If a report isn't available, you can usually find brief assessments of major families appended to individual Fund Analyst Reports. (Fund Family Reports and Analyst Reports are benefits of Premium Membership. Click here to start a free, 14-day trial.)
Can I get a discount?
Sort of. But generally only if you live in a state that charges an income tax.
Like the federal government, most income-tax states exempt qualified 529 withdrawals from taxation. And though there are a few miserly exceptions, that benefit is typically conferred whether or not you've invested in your home state's plan. Better still, some states allow deductions for plan contributions. A few states--Michigan, Minnesota, and Louisiana at last count--will even match your contributions, up to a certain limit.
These incentives shouldn't determine your choice, of course, but you should consider them carefully before making a decision. After all, a tax deduction or contribution match represents an immediate return on your investment.
Unfortunately, some states provide disincentives, punitive measures designed to bully you into staying in-state. Illinois, for example, not only taxes withdrawals from out-of-state plans but will also send you a bill if you decide to roll over contributions from these plans. (Hint: Don't do that.)
The moral of the story, as my colleague Langdon Healy explains, is that good research begins at home. As you mull your options, be sure you have a firm understanding of the tax consequences of leaving the state. Our list of 529 plans makes a good first stop because it allows you to sort the plans according to their state-tax benefits, including the maximum allowable deduction, if any, for your contributions.
There are a host of other issues to consider, of course, and we'll be covering those in upcoming articles. The issues outlined above, however, should be enough to keep you busy for a while. Happy hunting!