The 529 Ate My Tax Break
Hailed for their generous tax breaks, college savings plans sponsored by the states -- often called 529 plans, after the section of the federal tax code that created them -- are under fire. Among critics' concerns: The high fees that some plans charge can substantially erode -- and in extreme cases, even erase -- their tax advantages. As a result, participants risk handing over some if not all of the tax savings they realize by investing in a 529 to the mutual-fund companies hired to run the plans.
The solution is to shop carefully for the best deal -- comparing various plans' tax breaks, track records, and fees. (If you're already in a plan, you can switch your child's account once a year, free of taxes and penalties.) While that might sound straightforward, it isn't easy to decipher 529 fees. "You have to do a ton of work to find the cheapest plan -- and it shouldn't be so hard," complains Susan Dynarski, an assistant professor of public policy at Harvard University's John F. Kennedy School of Government. Dynarski should know: She recently scrapped a study of 529 fees because the charges are "buried, unclear, or so varied in their nomenclature as to make comparisons impossible."
It can be hard enough to understand the fees of a single program, never mind all 50 of these plans. Consider the fifth-largest in terms of assets, Maine's NextGen College Investing Plan. Of the dozens of investments on its menu, nine come with three price tags each. What you pay depends in part on whether you buy directly from the plan or through a broker. Some plans also levy extra fees that you must add to get a true picture of the cost. For example, if you've got the average 529 account balance of $8,200, the Maryland College Investment Plan's $30 annual account maintenance fee -- waived under certain circumstances -- adds 0.365% to fees that, in 2003, ranged from 0.82% to 1.15%.
The confusion over 529 fees has drawn attention from regulators and lawmakers. Congress held hearings recently, and the Securities & Exchange Commission formed a task force to study the level of fees and how they're disclosed. Meanwhile, the plans' trade group, the College Savings Plans Network, has written guidelines to standardize disclosure -- but only on a voluntary basis. That has drawn a skeptical response from House Financial Services Committee Chairman Michael Oxley (R-Ohio): On July 15, he asked the SEC to weigh in on whether the agency should regulate 529 plans.
GOING FOR BROKERS
Meanwhile, the National Association of Securities Dealers is investigating the sales practices of 16 brokerage firms that sell various 529 plans. (Some plans are sold directly to investors. But a growing number are sold either exclusively through brokers or can be bought either way.) Among the concerns, says NASD Vice-Chairman Mary Schapiro, is that with more than 90% of the dollars flowing into certain plans coming from out-of-state-residents, some brokers may not be adequately disclosing state income-tax deductions you can often get with your home state's plan. Twenty-seven plans offer state tax deductions, but only to those residents who keep their dollars in-state.
Fees can make a big difference in how much you're able to accumulate. Someone who invests $10,000 for a newborn will have $28,449 in 18 years -- assuming annual returns of 8% and average costs of 1.87%. But with fees of only 0.65%, you'd accumulate $35,534, or nearly 25% more.
Moreover, it makes no sense to contribute to a 529 plan if the fees eat up your tax savings. To gauge the prospects of that happening, calculate the difference between what you'll pay for a 529 and another investment. If you're in the 28% federal tax bracket and the 529 you're looking at offers a tax deduction, steer clear when the 529's price tag is 1.65 percentage points a year or more above that of a taxable alternative, advises Dynarski. Without a state tax deduction, the 529 becomes a bad bet when it costs 1.3 percentage points more. Since several plans, including offerings by Arizona and Rhode Island, feature options that charge about 2% a year or more, it's not hard to find situations where a taxable investment is the better deal.
To get a feel for how the plans' fees compare, you can find data on Web sites such as savingforcollege.com or morningstar.com. But since plans often charge a wide range of fees, you'll need to dig deeper to ascertain your potential costs.
Start with the "program description" or "plan disclosure" documents available at plan Web sites. (You can find links at www.collegesavings.org.) Be forewarned, though, that because disclosure is not uniform, the presentations vary. While some plans disclose fees in one place, others sprinkle the information throughout the reports. And while some states publish an all-inclusive number, others break out the parts.
THE NO-LOAD ROUTE
To get an apples-to-apples comparison, tally each plan's fees. Consider Colorado's Scholars Choice College Savings Program, run by Citigroup Asset Management (C ). Like many plans, this one sells no-load shares directly to investors who download an application or ask that one be mailed. You can also buy one of three share classes from a broker. The difference between them? Fees.
You're likely to come out ahead by buying directly. According to a table that lists total fees on page 34 of the disclosure, you'll pay 1.09% a year if you go the no-load route. Although annual fees on the "A" shares can be lower -- the range is from 0.85% to 1.14% -- you'll also forfeit 3.5% of your contributions to your broker. That means that for every $100 you invest, your broker pockets $3.50, leaving just $96.50 in your account.
To figure out your exact annual cost, you need to go two pages ahead, to a table which lists fees for the plan's eight underlying funds. The charges range from 0.44% on the Smith Barney (C ) Cash Portfolio to 0.94% on the American Fund's AFG EuroPacific Growth fund.
Most investors opt for an age-based portfolio, which automatically shifts money from stocks to bonds as college approaches. Say you have $10,000 to invest for a 10-year-old. To figure out the cost of the appropriate age-based portfolio, you'll need to look up how the plan allocates money for a child of 10 -- information that's on page 9 of the disclosure.
Of your $10,000 investment, 20%, or $2,000, will be invested in the Salomon Brothers Investors Value fund. Since the fund charges 0.66% of assets a year, that works out to $13.20 in fees on a $2,000 investment. Another 20% goes into the Smith Barney Large Cap Growth Fund. With fees of 0.76%, the tab on $2,000 is $15.20. Five percent more, or $500, of your investment is put in the Smith Barney Small Cap Core Fund, which charges 0.80% -- and so on. To arrive at your overall investment fee, calculate what you'll pay in dollars for each fund. Then, add the figures, and divide by your $10,000 investment. The result: about 0.73%.
That's not your total cost. According to the total fee table, on page 34, there's a 0.10% "Authority Administration Fee," which goes to Colorado to cover its expenses. This amount -- about average for 529 plans -- bumps you up to 0.83%.
You're not done yet. While fund and state agency fees come to 0.83%, the total cost for a no-load share is 1.09%. The 0.26% difference pays for marketing and record-keeping. Up to 0.30% is "reasonable," says Dan McNeela, a senior analyst at Morningstar.
Opt for an "A" share instead, and you'll pay a different price. On top of 0.73% in fund fees, you'll pay Colorado 0.10% and your broker 0.25% in "distribution fees." The total, 1.08%, is slightly less than the no-load's 1.09%. But once you factor in 3.5% initial sales charge, the A shares are far pricier.
Neither B nor C shares charge an up-front commission. However, since they respectively levy distribution fees of 0.95% and 0.75%, their totals come to 1.78% and 1.58% a year. That's below average for a broker-sold option, but above the 0.80% to 1.2% that Joseph Hurley, founder of savingforcollege.com, considers moderate for direct-sold 529s.
If you bail out of a B share within five years, you'll forfeit 0.5% to 2.5% of your money. After the seventh year, B shares convert to A shares. Meanwhile, if your broker is pushing C shares, you might be interested in the fine print that reveals that brokers get the highest annual payout from them -- 0.75%, vs. 0.25% for A and B shares.
Finally, if neither you nor your beneficiary live in Colorado and your balance is below $2,500, watch out. Colorado charges a $20 annual maintenance fee, which adds at least 0.80% to your cost.
Do these fees nullify the tax benefit? Depending on your tax bracket and the alternative investment you have in mind, they may. So do the math before committing your college savings to a plan that's going to fritter away your tax benefits.
By Anne Tergesen