Formula: Which 529 Plan Is Best?

William Baldwin for Forbes writes: You’ve got a dazzling array of choices when it comes to putting money aside for college. You don’t have to invest in your home-state plan, after all. Counting all the portfolios and share classes in the country, there are several thousand options for Section 529 savers.

I have a simple formula that will narrow your choices to two or three. It boils down to this: Is your home-state plan a good buy, taking into account any state tax advantage that comes from buying locally?

Here’s the formula:

E ?< T/N + 0.17%

E is the expense ratio in the home-state portfolio you are considering. T is the state tax bracket that applies to the deduction you’d get for investing at home. N is the number of years your money will be compounding before you use it.

The ?< just asks a question: Are my expenses low enough? Will they be less than the sum on the right? The 0.17% is the cost of the New York plan, available to anyone in the country. If the answer to the question is yes, then you’re better off buying into your own state’s plan than shipping your dollars to New York.

Example 1: You’re in Illinois in a 5% state tax bracket, your contribution to the account is low enough to be fully deductible on your state taxes, and the money will be in place for a decade. Then the quantity on the right is 5%/10 + 0.17%, or 0.67%. That’s the limbo bar that an Illinois 529 has to squeeze under.

As it happens, all of the choices Illinois offers are cheaper than this.

So you should stay at home in the Illinois plan. Moreover, for a reason I will get to at the end, you should opt for one of the cheapest items on the Illinois menu. That would be a passive index fund.

Example 2: You live in Hawaii. This state’s income tax offers no deduction or credit for 529 contributions. So T/N is 0%. Now the question is whether the investment options offered by the Hawaii plan are cheaper than the New York plan costing 0.17%. The answer is no: Hawaii’s plan charges 0.75%. So savers who live there should invest on the mainland.

States whose residents have excellent choices at home—by dint of low costs or valuable tax benefits—include Michigan, Utah and Wisconsin.

Locales with a combination of high costs and poor tax benefits include the District of Columbia, Florida, Kentucky, Montana, Nevada, New Jersey, South Dakota and West Virginia. If you live in a loser locale, send your money out of state.

In most places you won’t know whether to stay at home with your money until you look closely at the plan and you plug numbers into the formula. But here’s the pattern: The less time until the money will be used, and the higher your state’s income tax, the more likely it is that you can stomach a high expense ratio in the home plan. Not all states with an income tax grant relief to college savers, but most do.

The effective state tax rate used in the formula, T, should reflect the value (if any) of your plan contribution in reducing your taxes. It should be figured as a percentage of the money you’re putting in. For example, if investing $5,000 gives you a deduction of $5,000, and you’re in a 6% state tax bracket, then you’d put 6% in as the T value. Some states offer a credit instead of a deduction. If $5,000 gets you a credit of $300, your T value is 6%.

Careful calculators will allow for the fact that having a lower state income bill may raise their federal one. A 6% state tax benefit may be worth only 4% after the federal effect. But in many cases the arithmetic so strongly favors one plan over another that you can ignore this fine point.

Pay attention to the limits on the state tax benefit. If it allows a deduction of at most $5,000, but you want to put in $12,000, the optimum arrangement may be to invest $5,000 locally and send $7,000 to the cheap New York plan.

You can do a quick comparison of costs and tax goodies at Savingforcollege.com, an authoritative source of data on 529s. Follow screen options to compare 529 plans by features.

It doesn’t take long to figure out where your college money can be invested most efficiently. Do that and you can stop fretting about two other aspects of this decision process. One is how the portfolio is allocated. If the cheap portfolio is a 50/50 blend of stocks and bonds, but you wanted all stocks, take the cheap portfolio. You can adjust some other account, such as your IRA, to get your family’s overall allocations where you want them.

The other thing not to think about is performance. If you want to pay for active management, do that in a taxable account, where you can get a deduction for your mistakes. Tax-sheltered money should go 100% into index funds.