Choosing a Section 529 College Savings Plan

A Section 529 plan is a good way to leverage the money you save for your child’s education, but consider the advantages and disadvantages of individual plans before you choose one. Nearly every state has independently established its own Section 529 plan — some have several — and they’re not all alike.

There are two types of Section 529 plans, “prepaid tuition plans” and “college savings plans.” Prepaid tuition plans essentially allow you to pay future tuition costs at current tuition rates. College savings plans are investment accounts in which your contributions grow tax-free to pay for a beneficiary’s college expenses. These plans provide control, tax advantages, flexibility and estate planning benefits, which make them more attractive than some of the other college savings vehicles, such as the Coverdell Savings Account (formerly known as the education IRA) or Uniform Gift to Minors Act (UGMA) accounts.

Unlike UGMA accounts, in which you are required to relinquish control of the account assets to your child when she comes of age, Section 529 plans allow you to retain control.

Section 529 plans also allow for federal tax-exempt distributions (at least until 2011 when the Economic Growth and Tax Relief Reconciliation Act of 2001 expires) to cover qualified higher education expenses such as tuition, room and board, books and other supplies. Some states offer tax exemption for qualified withdrawals as well. You are allowed to transfer the assets to the account of another family member without taxes or penalties should your child decide not to go to college, or if there is money left over after college costs. Or you could make a non-qualified withdrawal from your plan account, which would be subject to taxes and a 10% penalty in most cases. (See “College Savings Plans Make the Grade” in the January 2002 issue of Sentinel, available at www.palisadeshudson.com for a more detailed description of Section 529 plan benefits.)

Our Favorite Plans

Fees and investment options are the most important criteria to consider when selecting a Section 529 plan. Annual expenses are deducted directly from the investment returns, so it is to your benefit to minimize these costs. The investment options generally consist of mutual funds that provide exposure to stocks, bonds, and cash-equivalent investments. You should choose a plan that offers broadly diversified portfolios of equities and bonds at low cost.

The College Savings Plan Network website, http://www.collegesavings.org/, lists 71 Section 529 plans available and eleven more anticipated to be available by year-end. We considered only plans that are in operation. We excluded all college savings plans that we deemed to be inflexible or that charged high fees. That eliminated all state plans closed to non-residents, all prepaid tuition plans, and all plans that charge initial or contingent-deferred sales loads.

Of the 38 plans left, we were especially fond of those with attractive cost structures, investment options consisting of low-cost, well-diversified underlying funds, and flexibility. Those included New York’s College Choice Tuition Savings Program, the Connecticut Higher Education Trust (CHET), Utah Educational Savings Plan Trust (UESP), and the College Savings Plan of Nebraska. (See table below for comparison.)

We found that the plans managed by TIAA-CREF and the Vanguard Group were among the best offered in terms of meeting our criteria. TIAA-CREF provides management and underlying mutual funds for 12 state plans (California, Connecticut, Idaho, Kentucky, Michigan, Minnesota, Mississippi, Missouri, New York, Oklahoma, Tennessee, and Vermont), and Vanguard provides these services for state plans in Iowa and Utah. State plans managed by the same investment company are not necessarily identical, however. Other national money managers that administer college savings plans include Fidelity and Merrill Lynch.

Most plans charge an asset-based management fee. The New York State College Choice Tuition Savings Program, for example, charges an asset-based management fee of 0.65%. of the plan’s average daily net assets. The fee for New York’s plan includes all underlying fund expenses. However, some state plans charge the underlying mutual fund expenses separately. The underlying mutual fund expenses are the fees charged by the individual funds to cover their management fees and operating and administrative expenses.

New York’s plan offers two age-based investment portfolios (Aggressive and Moderate) and two static portfolios (High Equity and Guaranteed). An age-based plan tries to lower the risk as the plan—or the beneficiary—matures. The age-based portfolios available in New York’s plan include a diversified U.S. large-cap growth fund; a bond fund consisting mainly of investment grade securities like U.S. Treasuries, government agency, corporate, and mortgage-backed bonds, with a small allocation to illiquid and non-investment grade securities; and a money market fund.

A static investment strategy does not change the allocation; it is fixed. The High Equity static portfolio consists solely of the TIAA-CREF Institutional Equity Fund, which is a broad stock market index fund that tracks the Russell 3000 Index. The Guaranteed static portfolio consists of an interest-bearing money market fund. Federal law now lets investors change their investment option once a year.

Depending on the investment option selected in the Utah Educational Savings Plan Trust, the annual maintenance fee and asset-based management fee are capped at $25 and 0.25%, respectively. Although Utah’s plan charges for annual maintenance, many other states that assess this fee are willing to waive it if you are a resident, make automatic deposits, or have a large account balance. Underlying mutual fund expenses are not included in the asset-based management fee, and range from zero to 0.07% based on a portfolio weighted average. When comparing the asset-based management fee and underlying fund expenses among plans, you must consider these fees in aggregate. The asset-based fee and underlying fund expenses for the Utah plan total 0.32% combined, which is approximately half of the asset-based management fee for New York’s savings plan. The UESP Trust offers two age-based investment schedules and two static portfolios. The age-based portfolios allocate assets among the Vanguard Institutional Index Fund, a U.S. large-cap equity portfolio that tracks the Standard & Poors 500 Index; the Vanguard Total Bond Market Index, a diversified fixed-income portfolio that attempts to replicate the performance of the Lehman Brothers Aggregate Bond Index; and the Public Treasurer’s Investment Fund, which is invested in money market funds. One static portfolio maintains a 100% allocation to the Vanguard Institutional Index Fund, while the other portfolio is invested entirely in the Public Treasurer’s Investment Fund.

With ten investment options, the College Savings Plan of Nebraska offers the most of any plan available. Nebraska’s plan has four age-based options (aggressive, growth, balanced, and conservative) and six static options, which vary based on their allocations to equity, fixed income, and money market instruments, and range from all-equity to 100% bond and money market. The College Savings Plan of Nebraska is managed by Union Bank and Trust Company, a Nebraska-chartered bank with more than $3 billion under management. Each investment option is composed of solid mutual funds from American Century, Fidelity, Janus, PIMCO, and Vanguard. Some of the underlying funds provide exposure to U.S. small-cap and international asset classes, which are not available in all state plans. Nebraska’s plan charges an annual maintenance fee of $24 and an asset-based management fee of 0.60% if purchased directly through Union Bank and Trust. Underlying fund fees are not included in the management fee, and range from approximately 0.32% to 0.44% based on a portfolio weighted average. If you buy through brokerage firms you will incur higher management fees, and sales charges may be assessed on the underlying funds.

Although we recommend Section 529 savings plans managed by TIAA-CREF and Vanguard, as well as Nebraska’s plan, you may find other state plans to be more suitable for your financial situation. Choose a plan that fits your needs.

Besides annual fees, investment options, and flexibility, you should consider the following criteria when choosing a plan:

Enrollment Fees. Fees charged for establishing an account vary. For example, Connecticut has no enrollment fee while Maryland charges $90. Annual maintenance fees tend to be minimal, but you still want to avoid them if possible.

State Tax Advantages. Look first at your own state’s plan. About 20 states, including New York, allow a tax deduction for contributions. Some states follow the federal tax treatment that makes the earnings tax exempt. Other states, while not exempting the earnings from tax, allow them to grow tax deferred. To get any of the state tax advantages of a plan you must be a resident of that state.

Eligibility. Certain plans limit how old the beneficiary may be when the plan is created. For example, Kentucky requires that the beneficiary be no older than 15. Other plans won’t let you start a plan if the beneficiary has advanced past the ninth grade. Still others require the account to be open for at least four years before a distribution can be made. Some plans have none of these limitations, such as Connecticut’s CHET plan and the Missouri Saving for Tuition Program (MO$T).

Portability. If the beneficiary of a plan intends to go out-of-state or to a private school, be sure the funds can be used at these institutions. Ideally, you want a plan that can be readily used with any public or private institution, in the plan’s state or elsewhere. This is the case with most college savings plans. Most prepaid state tuition plans tend to be limited to participating public colleges and universities, and often only a percentage of the assets can be used at private institutions.

Minimum/maximum contribution limits. The minimum initial contribution is typically between $250 and $500, but exceptions exist. Massachusetts has the highest minimum contribution ($1,000) for residents and Kansas has the highest for nonresidents ($2,500). The savings plans accept contributions until a certain account balance is reached. Currently, Tennessee allows the smallest balance ($100,000) and Rhode Island allows the largest ($265,620). However, you can establish separate accounts for multiple beneficiaries, or accounts in multiple plans for the same beneficiary, so these limits should not prove to be much of a problem.

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