Don't be fooled by 529 plan sticker shock

http://www.savingforcollege.com/articles/dont-be-fooled-by-529-plan-sticker-shock-635

College. As parents, grandparents and students we know it’s coming and that we’re somehow going to have to pay for it. Most of us won’t be able to treat tuition like a utility bill and simply write a check once the invoice arrives. Saving for college takes time and we often rely on investment growth to reach a certain goal. Fortunately we have many options available at our fingertips such as mutual funds, savings bonds, custodial accounts under UGMA/UTMA and of course, 529 plans. At Savingforcollege.com, we continue to find that in most cases the 529 plan offers the best savings potential.

Make the most of your college savings with a 529 plan

However, there are still many critics of 529 plans who are hesitant to invest because they feel that the fees associated with these types of plans will eat away at their earnings. A recent article featured on Morningstar.com points out that in almost every category, 529 costs are relatively high when compared to traditional mutual funds. This data comes from Morningstar’s annual 529 College-Savings Plans Industry Survey, which compares performance of 529 plans to open-ended mutual funds.

The study shows that although 529 fees have been declining in recent years, they are still having a negative affect on investment returns. So what makes these savings vehicles more expensive? The first reason is that 529 plans are run by the state, and states will sometimes hire an independent organization to handle administration, customer service and marketing. This, combined with the fact that 529 plans usually have a smaller asset base than most mutual funds, tends to result in a higher expense ratio.

Check out our 529 Fee Study.

For example, when we look at the expense ratios of 529 plans versus open-ended mutual funds in Morningstar’s Moderate Allocation category, we see a difference of 21 basis points, or 0.21 percent. That means if you invest $5,000 today in a mutual fund with an annual investment return of 6 percent, in 18 years you will have $12,074. However, a 529 plan with the same initial investment and annual investment return would only leave you with $11,647, a difference of $427.

However, this calculation leaves out one of the most lucrative benefits of a 529 plan – that earnings avoid federal taxes. Joe Hurley, founder of Savingforcollege.com, recently conducted another study that compared after-tax returns across all 529 savings plans to broad industry benchmarks, taking all asset-based investment and program management fees into account. In his groundbreaking Benchmarking the 529 Industry, Hurley found that when federal tax benefits were taken into consideration 529 plans beat their benchmark in every asset allocation category.

Looking at the example above, since the mutual fund investment is part of Morningstar's Moderate Allocation category we assume it is made up of 60 percent equities and 40 percent fixed income. To find the after-tax return, we adjusted the returns to include a 15 percent capital gains tax within the equity portion and a 35 percent ordinary income tax on the fixed income portion. Depending on the timing of capital gains tax recognition, you could hypothetically save up to $1,751 MORE for college with a 529 plan. For example, if capital gains are taxed annually, you would end up with only $9,896 in your mutual fund account, and if capital gains are taxed at the end of the 18-year period your potential return would be only $10,103.

Look up the tax benefits offered by your state.

Fee comparison is a crucial step in deciding which 529 plan to save with. Costs associated with the plan can put a dent in your college fund that could limit your choices down the road. However, we want our readers to understand that if you are contemplating whether to invest with a 529 plan or other savings vehicle there are other factors to consider. As Joe Hurley has shown us, the tax benefits of a state sponsored 529 college savings plan generally outweigh their higher costs. If you’re hesitant to open a 529 account because of fee sticker shock, think of the tax benefits as a coupon that will give you an unbeatable discount!