Stan Luxenburg for WealthManagement writes: More families have been discovering 529 college savings plans. In fact, assets in the plans jumped 25 percent in 2012 to $166 billion, according to Morningstar. But not all the plans are equally appealing. Some come with high expenses and uninspiring investment track records. According to a recent study by Morningstar, the average 529 investment returns lagged behind comparable mutual funds. Some choices performed so badly that savers would have done better by avoiding 529s and investing in taxable mutual funds.
And yet, at a time when families worry about saddling the younger generation with education loans, it’s even more important for advisors to steer clients to the best selections. “When they sit down with clients to make comprehensive plans, advisors can also provide value by discussing 529s,” says Paul Curley, director of college savings research for FRC, a division of Strategic Insight.
Tax-Free College Savings
The case for using 529s is compelling. Under the rules, a saver can set aside more than $200,000 and not pay any state or federal taxes on the earnings—provided the money is used to pay for college tuition. In addition, many states offer sizable deductions. Each state sponsors its own 529, but you are free to invest in any plan you like. Popular choices for out-of-state investors include plans from Maryland and Alaska.
While states such as California and Pennsylvania offer no incentives to keep the money at home, some states provide hefty rewards for stay-at-home investors. A couple in New York can reduce state taxes by deducting up to $10,000 annually. For high-income investors, that can result in tax savings of more than $500 a year.
Bargain Shopping
Even if a client’s state offers a deduction for using the home plan, advisors should still shop around the country for the best choice; fees vary widely. Annual expenses range from 1.74 percent for the Iowa Advisor 529 Plan to 0.25 percent for the Michigan Education Savings Plan. Part of the reason for the varying costs is that many states tack on an extra layer of fees. In a typical arrangement, a 529 portfolio invests in a group of mutual funds. So investors must pay the normal expense ratios of the funds. In addition, some plans charge administrative fees. As a result, 529 investments tend to be more expensive than conventional mutual funds. While the average moderate allocation mutual fund charges an expense ratio of 0.99 percent, comparable 529 funds charge 1.22 percent.
States typically offer two classes of shares: advisor shares that come with loads and direct-sold options that are designed for do-it-yourself investors. The loads are similar to the sales charges on mutual funds, with front-end charges ranging up to 5.75 percent. In the past, most sales came from advisor-class shares. Virginia’s plan, which features load selections from American Funds, has been a popular choice with advisors around the country. But lately direct-sold plans have been gaining more traction, and they now account for half of all assets in 529s. “We are seeing more fee-only planners and RIAsbuying direct-sold plans,” says Joseph Hurley, founder of Savingforcollege.com.
Many funds allocate assets based on the age of the child. As college enrollment approaches, the portfolios become more conservative. In a typical approach, an investment for a newborn has 80 percent of assets in stocks and the rest in bonds. For a 19-year-old, stocks only account for 10 percent.
For advisors seeking a low-cost alternative, a top choice is the New York plan. The direct-sold portfolio for children ages 0 to 5 has an expense ratio of 0.17 percent. Designed to please diehard passive investors, the portfolio includes two Vanguard index funds. For moderate-risk investors, the portfolio has about 75 percent of assets in Vanguard Institutional Stock Market Index (VITPX) and 25 percent in Vanguard Total Bond Market II (VTBNX). So far the simple approach has produced winning results. During the past five years, the portfolio has returned 7.1 percent annually, topping average competitors by 4 percentage points.
For advisors who sell load funds, a top choice is Oregon’s MFS 529 Savings Plan, which has an annual expense ratio of 1.37 percent. The high-equity choice for children aged 0 to 6 has about 92 percent of assets in stocks. During the past five years, the portfolio returned 4.1 percent annually. The assets go to a mix of solid MFS funds, including MFS International Growth R5 (MGRDX), MFS Global Real Estate R5 (MGLRX), and MFS Mid Cap Growth R5 (OTCKX).
The Structure of 529s
Many of the states use what is called closed architecture, relying on funds from one company. Other choices are open architecture, offering choices from several companies. A solid open-architecture choice is the Illinois Bright Directions program. The moderate portfolio includes top performers, such as Oppenheimer International Growth (OIGIX), PIMCO Total Return Institutional (PTTRX), and Templeton International Bond (FIBZX).
While many clients prefer age-weighted portfolios, it is also possible to buy and hold a single stock fund. A top choice is the Illinois program’s large value selection, which puts all its assets in American Century Value (AULIX). During the past five years, the fund returned 5.7 percent annually, outdoing the average large value competitor by 2 percentage points.
Picking an individual fund could be an appealing solution for high-net-worth clients, says Andrea Feirstein, managing director of AKF Consulting. Say a family already has a broadly diversified portfolio with extensive stock and bond holdings. The 529 offers a chance to shelter an individual fund that would otherwise be in a taxable account. “If the 529 fund collapses just before the child enters college, you can delay withdrawing the money for a few years until the market rebounds,” Feirstein says.
What if you fail to spend all the money in the account on the child’s tuition? You can keep the money in the tax shelter and use it later—perhaps paying for a younger child or a favorite nephew.
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