Your Best 529 College Savings Plan May Be in Another State
How 529s work and an explanation of costs and taxes
Amid record levels of student loan debt, many households are focused on saving for future college costs. As of midyear 2019, 14 million 529 College Savings Plan accounts had combined assets of more than $350 billion. Yet a common misperception about 529 rules can lead to choosing a plan that is more expensive. And as with all matters investing, lowering your costs is the surest way to improve returns.
Quick background: A 529 savings plan offers valuable federal tax breaks and is sort of like a Roth retirement account. You save with after-tax dollars, but savings grow without any IRS tax bill, and when withdrawals are made to pay for qualified educational expenses – tuition, room, board, etc. — there is no tax owed on any investment gains. Moreover, there is no income limit; anyone can set up a 529, and as a practical matter, it’s unlikely you will ever bump up against the savings limit. According to savingforcollege.com, you can have as much as $265,000 to more than $500,000, per account, depending on the state you live in.
Named after a part of the federal tax code, the 529 industry has a confusing structure that might lead savers to settle for a sub-optimal plan. Most every state offers its own 529 plan. And in some states, there can be an in-state income tax deduction, or even a grant (think matching contribution) for income-eligible participants. But there is absolutely no requirement that you must use your state’s 529 plan. You can save in any 529 plan sponsored by any state, and then use the money to help pay for college expenses at just about any school.
That creates an opportunity for many households to cross their state borders and shop nationally for the best 529 plan. States where you have no incentive to automatically choose the in-state plan:
Residents of the seven states that don’t have an income tax to contend with: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
Residents of states that levy an income tax but don’t allow a deduction for 529 contributions: California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, North Carolina and Tennessee. (Note: Tennessee’s tax is on investment income, not salary and wages.)
Residents of seven enlightened states that offer up the deduction regardless of which state’s plan you choose: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana or Pennsylvania.
If you are a resident of any of those states, you might want to consider comparing your state’s plan to other options. A main consideration is the cost of investing in a 529. As with your 401(k) and IRA investments, low costs should be a central goal. The less you pay in annual fees to save for college, the more you will have on hand to pay for college.
The first step to manage your 529 investment fees is to steer clear of advisor-sold 529 plans and invest in a direct-sold 529 plan. According to investment research firm Morningstar, in 2018 the average annual 0.90% expense ratio (fee) for advisor-sold 529 plans was more than double the typical fee for direct-sold 529 plans. There are plenty of fee-only financial advisors who can give you planning advice — including strategies for 529 savings — for an hourly or project fee and you can then use the lower-cost direct-sold fund.
Morningstar’s 2019 ratings of 529 plans gave three plans a gold rating, mainly reflecting their solid lineup of investment choices and low costs. The Illinois Bright Start Direct-Sold College Savings Plan and the Virginia Invest529 have an all-in annual fee of as little as 0.10%. The Utah my529 plan has fund choices that start as low as 0.13%.
You can learn more about 529 plans, and compare your in-state options to low-cost, out-of-state plans at the savingforcollege.com website.