A young couple came to me recently because they received a parental gift of $40,000 and wanted to know how to maximize their college savings. They are DC residents so they were naturally curious about the DC 529 College Savings Plan.
If you don’t know already, 529 plans are a great way to save for college. Nearly all states have 529 plans. A 529 plan allows contributed money to grow tax free and to be withdrawn free from federal and state taxes if it is used to pay for qualified college expenses like tuition, room and board, and books. State residents often receive a state tax deduction for their contributions. In DC, the tax deduction is $4,000 for an account owner per year (or $8,000 for a married couple that own two accounts). Unfortunately, there isn’t a federal tax deduction for contributions. There generally are no restrictions on residents of one state investing in the plan of another state. Of course, residents of one state cannot receive in-state income tax deductions for contributions to another state’s plan.
The couple asked whether it made sense to contribute all of their gift money to the DC 529 Plan. I suggested two things for them to consider. First, I suggested that they open two accounts, each spouse owning one account and naming their child as the beneficiary of each account, so that they are eligible for the total $8,000 DC tax deduction. Second, I wanted them to consider the available investment funds in the DC plan and their associated fees. The DC 529 Plan has a limited number of funds from which to choose and these funds carry high expense levels. And as you know, the higher the fund’s expenses, the lower the fund’s performance return. So I looked at other state plans for possible places to contribute their money.
Morningstar, the investment analyst firm, ranks Utah (Utah Educational Savings Plan) and Nevada as great plans for out-of-state savers due to their low costs and varied investment choices. So I compared the DC and Utah plans on the two main types of investment funds in each plan – age based funds and static funds (which don’t vary with age).
When you open an account and invest in an age-based fund, you select the portfolio that corresponds to the age of your child or other beneficiary. As your child gets older, the fund’s assets are automatically moved to the next appropriate age-based portfolio. In general, the portfolios become more conservative over time. That is, a smaller portion of the portfolio is invested in stock funds that tend to be more volatile and more is invested in bond funds and in cash.
The DC 529 Plan fees for the age-based funds are substantially higher than comparable funds in the Utah 529 Plan. For example, the DC Age 0-5 Fund has a fee of 1.29% per year whereas the comparable Utah fund (the Age-Based Moderate 0-3), has a fee of 0.219%. That 1% savings on a $5,000 annual contribution over an 18-year period can mean an additional $8,000 return in the Utah Plan’s fund compared to the DC Plan. Because fees are netted against the fund’s return, it is not surprising to see that the investment performance of the DC plan fund has been lower by nearly the same percentage compared to the Utah fund.
A quick look at DC’s and Utah’s static investments draws the same conclusion. Static fund offerings include stock and bond mutual funds that invest in various segments of the market. One of the most popular of these funds is a fund that invests in large domestic U.S. companies as measured by the S&P 500 Index. The DC Plan’s State Street 500 Fund, which is an index fund that mirrors the performance of the S&P 500 Index, has an expense rate of 0.46% compared to the same fund in the Utah Plan that has an expense rate of 0.2%. Again, the return on the DC Plan fund has been lower than the Utah plan for a nearly identical fund by the expense rate differential.
So what did my client do? First, they maxed out on the DC plan tax deduction. They each set up an account and named their child as the beneficiary. They each contributed $4,000 to their newly established DC 529 accounts. The DC tax break on the $8,000 combined contributions is over $600. They invested these contributions in the lowest cost DC fund, which is the State Street Bank 500 Fund. They believe they will be able to contribute additional money over the next several years in order to max out on the annual DC tax deduction of $8,000.
They invested the remaining money ($32,000) in a Utah fund to give them broader diversification (that is, not all stocks) at a much lower cost that compared DC Plan funds. In this case, they invested in Utah’s static 70% equity / 30% bond fund. They intend to contribute more in the Utah plan as money becomes available. They plan to adjust these investment choices (to be more conservative) once their child is about 5-7 years away from entering college.
So the lesson here was to stay with the DC 529 Plan only to get the annual income tax deduction. Contribute any additional money for college savings to a much lower-cost plan so that your overall return won’t be eaten up by fees in high-cost funds.