How to Select the Right 529 Plan

By Richard A. Anderson

For parents looking to save for their child’s future educational expenses, 529 college savings plans are highly regarded as the best way to save. A 529 account allows you to invest and grow assets free from federal and state taxes, as well as tax-free withdrawals for qualified educational expenses. In addition, many states offer residents tax benefits for 529 plan contributions. These benefits make saving for college through a 529 plan a slam dunk.

So, you have decided it’s a good idea to start making contributions to a 529 plan. Which 529 plan do you choose? Since you can invest in any state’s 529 college savings plan, it’s important to consider all of the plan’s features. The most important features to consider are:

Tax Benefits: As previously mentioned, many states offer residents a full or partial tax credit or deduction for contributions to their state’s 529 college savings plan. Some states offer a tax deduction for contributing to any 529 plan, including out-of-state plans. There are 28 states that offer tax benefits for contributions made to in-state 529 plans only, 6 states that offer tax benefits for contributions to any 529 plan, and 16 states that offer no tax benefits for contributions to a 529 plan.  These tax benefits are typically subject to income limits and phase-outs.

Expenses and Fees: The fee structure of 529 plans often have three different components: operating expense ratios of the underlying funds, administrative/program management fees, and sales charges. The operating expense ratios of the underlying funds and administrative/program management fees are calculated as a percentage of the account value and are referred to as asset-based fees. These fees cannot be avoided, but the level can vary significantly between plans.

For example, the NY’s 529 College Savings Program has a total annual asset-based fee of 0.15%. In comparison, the NJBest 529 College Savings Plan has a total annual asset-based fee that ranges from 0.14% to 0.89%.

Unlike operating expense ratios of the underlying funds and administrative/program management fees, sales charges can and should be avoided. Most 529 plans do not have sales charges, but some 529 plans sold by commission-based brokers do have either upfront initial sales charges or deferred sales charges. Sales charges directly conflict with your ultimate goal of accumulating funds for college payments.

For example, some plans charge a 5.25% initial sales charge on any funds contributed to a 529 plan. This means for every $100 contributed, only $94.75 is actually being invested. That’s not beneficial for you, but it is beneficial to the person who receives a commission based on your contributions.

Investment Choices: The investment choices available under each state’s 529 plan vary depending on the investment manager of the plan. For example, the investment manager of the NY’s 529 College Savings Program is Vanguard, so the investment choices are Vanguard index-tracking mutual funds. In comparison, the investment manager of the NJBest 529 College Savings Plan is Franklin Templeton, so the investment choices are Franklin Templeton actively managed mutual funds.

Most 529 plans have investment options that fall under three broad categories: age-based options, risk-based options, and individual portfolios.

Age-based options are portfolios that gradually become more conservative as the beneficiary approaches age 18. Age-based options typically come with a choice of risk level depending on your comfort level with risk. The age-based option is an easy set it and forget it approach.

Risk-based options are static portfolios that target a certain level of risk. For example, you may choose an allocation that is 60% stocks and 40% bonds. The difference between the risk-based options and age-based options is that risk-based options do not automatically become more conservative over time.

Individual portfolios allow the 529 plan owner to construct their own portfolio to reflect their risk tolerance and beneficiary’s time frame. Unlike the risk-based options, individual portfolios do not automatically rebalance to keep the allocation in line with your strategy. Like the risk-based option, individual portfolios do not automatically become more conservative over time.

If you’re lucky enough to live in a state that offers a tax deduction or credit for contributing to that state’s 529 college savings plan, that’s most likely your best option. The tax benefit will typically outweigh any difference in plan costs or performance over time.

However, if you live in one of the few states that offers tax benefits for contributions to any 529 plan or live in a state that doesn’t offer any tax benefit for contributions to a 529 plan, plan costs and investment choices are important considerations. Plan costs are easy to compare because every plan publishes their costs in disclosure documents made available on their websites.

Investment choices, on the other hand, can be more difficult to compare. As mutual fund companies are quick to point out, past performance is not a guarantee of future results. However, one easy difference to spot is whether the plan uses actively managed or passively managed investment choices.

A more difficult difference to spot is the glide path, or gradual change in the plan’s asset allocation mix for age-based options. The glide paths for most age-based options are similar, but there are definitely differences in the age of the beneficiary at which the portfolio becomes more conservative and how conservative the portfolio gets.

At HIGHLAND, we evaluate these three major features, as well as a handful of more minor features, when recommending the most appropriate 529 college savings plan for you. Please contact a member of the HIGHLAND team to learn more about choosing the right 529 plan for your needs.