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Special Report

Digging into a 529 Plan

We size up a college-savings plan with respect to three key criteria.

In earlier columns, my colleagues and I have outlined some of the issues college-savers should consider before taking the 529 plunge. We've profiled a couple of plan providers as well. Recent articles have highlighted the pros and cons of plans managed by TIAA-CREF and Vanguard, two of the mutual fund industry's low-cost providers.

In this column, I'll drill down from there and focus on the merits of a particular 529 offering--Massachusetts' U. Fund College Investing Plan. I'll examine how this case study rates in terms of three key criteria all 529 investors should consider: investment flexibility, fees, and incentives. Along the way, I'll put the plan's particulars in a broader context for investors who are mulling other options.

Investment Flexibility
The Bay State's plan comes up a winner in terms of investing flexibility. Managed by Fidelity, the plan offers a plethora of choices built around an "age-based" track and three static options. Think of the former as an asset-allocation fund whose manager ratchets down equity exposure in favor of fixed-income investments as your beneficiary approaches college age. Over time, this option moves from a maximum equity exposure of 88% to a tame, college-age portfolio in which stocks account for just 20% of assets.

The static options, meanwhile, include three portfolios: an aggressive, all-equity option; a moderate portfolio that features a 70/30 split between stocks and bonds; and a conservative option that invests exclusively in fixed-income instruments. Participants may also choose a custom approach and divide contributions among any three of the plan's age-based or static portfolios to achieve an asset mix that suits their goals and risk tolerance.

Those options give plan participants plenty of room to maneuver, but investment flexibility, of course, is only as useful as the options are strong. Fortunately, the quality of the plan's underlying funds is also quite high. Fidelity stalwarts such as  Dividend Growth (FDGFX),  Growth & Income (FGRIX), and  Spartan 500 Index (FSMKX)--a low-cost index offering--are available in most portfolios. All told, 13 of the plan's 18 funds have earned 4- or 5-star ratings, and Fidelity, one of the fund industry's premier shops, supports the plan with a large team of talented managers and a small army of analysts who provide behind-the-scenes research.

And that raises an important point: All investors should evaluate the strength of the shops that manage the plans they're considering. Some, such as Vanguard and Fidelity, have sterling reputations and ample resources. Lesser-known outfits, however, will likely require greater scrutiny.

Fees
The Massachusetts plan doesn't fare quite as well when it comes to expenses, but it's not among the pricier offerings, either. The expense ratios of the underlying portfolios here range from 0.58% to 0.86%, and Fidelity tacks on an additional 0.30% management fee for their services.

529 plans, unfortunately, don't typically come with a single price tag for comparison purposes, but we estimate that expenses here would take back 1% of annual returns for investors in the age-based option that comes closest to a 50/50 mix of stocks and bonds. Moreover, unless contributions are made automatically or total $25,000 for a given beneficiary, Fidelity also assesses a $30 annual maintenance fee. (These fees aren't unusual, but you should expect them to be waived once your balance reaches a predefined minimum or if you agree to make automatic deposits.)

All told, cheaper options are available, but relative to the typical 529 plan, this offering's price tag is moderate. Our recent survey of plan expenses found that offerings with expense ratios of less than 1% are relatively inexpensive. Those that cost more than 1.25% are pricey. (Click here for Morningstar fund analyst Langdon Healy's recent article on 529 plan expenses.)

Incentives
Generally speaking, we think investors should begin their 529-plan research with their home states' plans, owing mainly to the tax benefits they may receive for investing at home. Deducting the amount of your contributions from your taxable income, after all, represents an immediate return on your investment dollar.

Unfortunately, the U. Fund College Investing Plan comes up short in this category. True, as with all plans, invested contributions grow on a tax-free basis, and, beginning this year, qualified withdrawals are free from federal taxes, too. At the state level, however, Massachusetts provides no incentive for Bay Staters to stay home. Indeed, while many states allow at least partial deductions, contributions here are fully state taxable. And while qualified withdrawals for educational expenses are exempt from state taxes, Massachusetts doesn't tax distributions from other states' plans, either.

Bottom Line
Despite the lack of state-tax incentives, we think the U. Fund College Investing Plan stacks up as a decent option for Massachusetts residents and even for those nonresidents whose states' plans are poor or offer no incentive to stay home. In short, the plan features superior funds, a topnotch manager, and ample investment flexibility.

That said, while the costs here aren't prohibitive, Massachusetts gives Bay Staters no reason not to mull cheaper, out-of-state options, such as Utah's Educational Savings Plan Trust. This plan is open to nonresidents and features a clutch of low-cost index funds from the highly regarded Vanguard fund shop. Moreover, we estimate the total cost to investors in this plan's age-based 50/50 option to be just 37 basis points.

And who knows? If enough Bay Staters vote with their pocketbooks, perhaps Massachusetts will eventually sweeten the tax deal for its residents. Stranger things have happened.