I was asked recently whether it made financial sense to contribute more than the state income tax deduction amount of $2,500 per account holder per account to the Maryland College Savings Plan.
Maryland maintains two distinct plans:
- The College Investment Plan, which offers stock and bond mutual funds. The investment earnings are not taxed as long as you use them for qualified higher education expenses (tuition, room and board, fees, etc.).
- The Prepaid College Trust Plan, which offers semesters of in-state Maryland colleges at today’s prices. No matter how much the cost of tuition increases in the future, you have paid the tuition for the semesters purchased. The investment you purchase can be used for in-state, out-of-state, private, and technical colleges nationwide.
They are different programs. The discussion below focuses on the College Investment Plan. A future blog will discuss the merits of the Prepaid College Trust Plan.
I discussed similar questions about the District of Columbia and Virginia 529 Plans recently. In short, the DC 529 College Savings Plan is an expensive plan. I suggested that DC Plan account owners contribute just enough to receive the maximum annual DC income tax deduction and invest remaining funds in the Utah 529 College Savings Plan. The Utah plan provides broader diversification (that is, not all stocks) at a much lower cost than compared to the DC Plan funds. By contrast, the Virginia Plan offers low-cost static allocation and building block funds that you can use for college savings beyond the maximum allowable state income deduction without having to go out of state.
I wondered whether the Maryland College Investment Plan was better than the DC or Virginia Plans such that Maryland residents would not have to invest out-of-state to get a better selection of funds at a lower expense rate. In short, it isn’t. So like the DC Plan, invest the maximum to get the Maryland state income tax deduction and invest any other fund in the Utah plan.
Of course, before funding kids’ education, I generally counsel clients to make the annual maximum contribution to their 401k or work retirement plan of $18,000. Retirement contributions are deductible for both federal and state purposes whereas 529 contributions are deductible only for state income tax purposes.
Maryland Investment Plan’s Age-Based Funds
I compared the Maryland 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). Morningstar, the investment analysis firm, gives both the Maryland and Utah (Utah Educational Savings Plan) their highest rating so I was interested to see how they compared.
When you open an account and contribute to an age-based fund, you select the portfolio that corresponds to the age of your child. As your child ages, the fund’s assets are automatically moved to the next appropriate age-based portfolio. The investment portfolios become more conservative over time. A smaller percentage of the portfolio is invested in stock funds that tend to be more volatile and a larger percentage is invested in bond funds and in cash.
The asset allocation scheme – the percentage of stocks and bonds in a fund – is the most important determinant of the fund’s performance. The second most important factor is the fund’s expense rate. Funds with lower expense rates do better over time because fewer fees are subtracted from the fund’s earnings.
The comparable age-based funds in the Maryland College Investment Plan are slightly more expensive (higher expense rate) than the Utah Plan. And looking at comparable Utah plans, the Maryland plans have not performed as well on a three-year or five-year annualized return basis. Part of this lower performance is due to the higher fees associated with the Maryland funds.
For example, the most aggressive age-based fund in the Maryland College Investment Plan is the Portfolio 2033 fund, which is aimed at students starting their freshmen year in 18 years. It is invested 100% in stocks and it carries an expense rate of 0.80%. The comparable Utah fund (the Age-Based Aggressive 0-3), has a fee of 0.19%. That 0.61% savings on a $5,000 annual contribution over an 18-year period can mean an additional $8,000 in available funds.
Moreover, the five-year annualized return for the Maryland 2030 Portfolio (which is also 100% invested in stocks and a good comparison for the Utah fund) was 10.46% compared to the Utah Plan of 12.83% – a two percentage point difference, which is significant over time.
The other important feature of the Maryland age-based funds is how aggressively they are invested in stocks until about five years away from the target date. Both the Portfolio 2033 and 2030 funds are invested 100% in stocks and carry the same expense rate (0.80%). The Portfolio 2027 fund is 88% in stocks and 12% in bonds and carries the same expense rate as the other funds at 0.80%. Even the Portfolio 2021 (college starts in six years) has a 57% allocation to stocks.
The Utah plan, however, has aggressively allocated age-based funds as well as moderately allocated age-based funds that allow you to choose the risk level you prefer. The Utah plan is more flexible in that way.
Maryland Static Investment Funds
A quick look at Maryland’s and Utah’s static investments shows that the Maryland funds are more expensive than the comparable Utah Plan funds. Static fund maintain the same asset allocation over time.
For example, the Maryland Balanced Fund maintains a 60% stock / 40% bond asset allocation and has a 0.79% expense rate. The comparable Utah Plan’s fund has an expense rate of 0.206%. So if you are looking for static investments, the Utah plan’s options, which are more numerous than the Maryland’s plan, may be the better option.
My recommendation for Maryland residents is to invest in the Maryland College Investment Plan to obtain the Maryland state income tax deduction. For contributions above that amount ($2,500/year per account holder per account), the Utah plans offer greater return, fewer expenses, and many more choices. These additional choices are doubly important if you are not comfortable with the larger amount of risk that the Maryland age-based funds entail.