Which state 529 plan should you choose?

529 College Savings plans have become the default go-to plan for parents and grandparents to stash some money away for the little ones.  Not surprising, given that 529 plans offer the significant benefits including large contribution limits, potential income and estate tax benefits and often most appealing control by the grantor/owner.A question that clients often ask when considering opening a 529 plan is "does it matter which state 529 plan I choose?"To answer that question there are several question that you should consider:

Can I receive a tax deduction for contributions to my state's plan?Most states offer an deduction on your state income tax for making contributions to your home state's 529 plan.  According to the colleges savings website FinAid.org, 35 states including the District of Columbia offer a tax deduction or tax credit for contributions to their state's 529 plans.  Out of the remaining 16 states, seven don't have a state income tax from which to give you a credit or deduction.  Nevada, home to one of our offices, is among those states with no state income tax.  That leaves nine states which levy a state income tax, but don't offer any tax benefit for contributions to the state's 529 plan.  California, where our company's primary operations (and many clients) are located, are among the nine states which have a state income tax but no deduction or credit for contributions to the state's 529 plan.

The tax benefit offered by each state varies considerably.  The most generous states do not have a limit on how much you can deduct, with some offering an unlimited above the line deduction with carry forward of excess contributions.  Depending on the amount of your taxable income and your state's income tax rate, that can be a very generous tax benefit.  However, some states offer only a small benefit for 529 contributions.  An example of this is Maine which only allows a deduction for contributions up to $250.  Even that deduction phases out for incomes above $100,000 for single filers and $200,000 for married couples filing joint.

If your state offers a tax deduction or credit for 529 contributions, you should strongly consider starting your search right at home.  However, you should weight the quality of the plan against the benefit of the tax deduction.  A state tax deduction might not compensate for a poor plan with high internal expenses and sub-par investment selection.Of course, if you are in a state that does not offer a tax deduction or credit, or one in which you don't pay state income taxes, then there is no particular benefit to going with your state's plan.

Watch out for those fees!

This is a common rule that you can repeat for any type of investment, low expenses don't guarantee good performance, but high expenses are a surefire formula to inhibit portfolio performance.  Most 529 plans expenses are broken up into a few different categories:

Underlying fund fees:  Investment options in a 529 plan are much more akin to your employers 401k plan; there will be a menu of fund options to choose from.  Generally, each plan offers a target date style option which aims to reallocate more conservatively as the child approaches college age, much like the target date fund in your 401k shifts to more conservative investments as you near retirement.  There are also likely individual fund options available.  This will generally include both a large and a small cap US equity fund, a couple of international equity funds and a few fixed income funds.  The individual fund options offer more flexibility and customization, but leave the reallocation to you or your advisor as your child grows.  Underlying fund fees should be fairly low.  As an example, the 2024 College Portfolio in the iShares 529 plan has underlying investment expenses of 0.243%.

Program Management Fee:  529 plans require additional service and administration above ordinary ETF or mutual funds.  Virtually all 529 plans charge a Program Management Fee in order to cover those expenses.  Some are as low as 0.10% or 0.15%, while others will run closer to a full 1%.  This is often one of those "hidden fees" that you are always warned to look out for.  Be sure you know how much your plan charges before you invest.

State Administration Fee:  Most states tack on an additional 0.05% or so (some more, some less) for the State Administration Fee.  Being honest here, I'm not sure what expenses the state might be incurring that it is being compensated for.  But since they have their hands in pot, you should watch out for states that charge extra high admin fees.

Broker Commissions:  a large number of 529 plans are still offer brokers a sales commission for selling the plans.  These fees can become extremely high.  For example, here's the expense disclosure for the New Jersey Franklin Templeton plan:

Franklin Templeton 529 College Savings Plan offers multiple share classes. All share classes pay underlying fund expenses (currently up to 0.88% of assets) and the current annual program management fee of 0.40% of plan portfolio assets. Class A shares have an initial sales charge of up to 5.75% and an annual sales fee of 0.25%; Class B shares have a contingent deferred sales charge which is 4% in the first year, declining to 1% in the sixth year and eliminated thereafter and an annual sales fee of 1.00%; Class C shares have a 1% contingent deferred sales charge and a annual sales fee of 1.00%.

Yikes!

Investment options

It's important for your 529 plan to have good investment fund options.  However, your definition of good investment options might differ from another's.  You can find 529 plans that offer actively managed funds, index funds or blended funds. Many will tout fund performance as a reason to consider their plan.  Of course, we can all recite the small print, "past performance does not guarantee future results."Instead of chasing the best performance, make sure the plan offers funds that are consistent with your view of how markets work.  Do you believe that a good manager should have the ability to outguess and time markets?  If so, seek a plan that includes active managers.  Do you believe that markets are basically efficient, making market timing and superior stock picking more often than not a losing proposition?  Then you should find a plan that offers index or passively managed funds and ETFs.

A Gold Star

Like ratings of mutual funds, ratings of 529 plans are limited to by the criteria and methodology of ranking.  However, I believe that it's still a valuable component in making an informed decision.  Morningstar, popular for their mutual fund star ratings, publishes an annual rating of 529 plans based on what they call their "five pillars," Process, Performance, People, Parent, and Price.  Here is a link to their 2013 529 plan ratings (opens in pdf).