New DC 529 Plan is a Missed Opportunity

money photoThe District of Columbia recently revamped its 529 College Savings Plan. The new plan offers lower cost investment options than the old plan’s offerings. DC also eliminated the high-cost advisor sold option!

These changes are a welcome improvement.

DC, however, missed an opportunity for its 529 plan to become the low-cost leader.

And I don’t understand why.

I assumed that the DC Government shared my vision that DC should be the model for other states. Not just in this area, but in a vast number of areas that affect the day-to-day finances of DC residents – insurance regulation, home buying costs, retirement savings. Ah, to be disappointed by our leaders…

I stand by my prior recommendation that DC residents should continue to invest only the amount in the DC 529 Plan necessary to get the DC annual tax deduction ($4,000 per account holder or $8,000 if a married couple has two accounts).

Use a lower cost plan such as the ones offered by Nevada, New York, or Utah if you have more money to contribute to your child’s college education. All three plans offer low-cost investment funds and have lower annual fees compared to the DC 529 Plan. Lower costs mean better returns for you.

529 Plan Background

A 529 plan allows your contributions to grow tax free. You don’t pay federal or state taxes on the investment gain if you use funds 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 are no restrictions on residents of one state investing in the plan of another state. Residents of one state cannot receive in-state income tax deductions for contributions to another state’s plan.

Observations on the New DC 529 Plan

I want to highlight two changes to the two types of investment funds in the DC 529 plan: age-based and static funds. The changes relate to the glide path of the age-based funds and the expenses of both types of funds.

Age-Based Funds

The theory behind an age-based fund is to choose a fund that matches the year when your child starts college. The DC 2034 fund is students starting college in 2034 (the “target” year).

As the target year approaches, the fund’s assets are automatically moved to the next appropriate age-based portfolio. The portfolios become more conservative over time. That is, stock funds have a smaller part of the portfolio because they are more volatile. The fund will contain more bond funds, which have lower overall returns but do not have as many up and downs as stock funds.

This trajectory from stocks to bonds is the glide path.

The DC 529 plan age-based funds have a moderate to conservative glide path. For example, the DC 2034 Portfolio fund has a 20% bond fund share even though the target date is 17 years away. Likewise, the 2031 Portfolio has 35% in bond funds 14 years before the target date.

A conservative glide path is not bad on its face. But moving to more bonds funds sooner may leave gain on the table when the stock market is rising.

I usually recommend that investors start to increase their bond exposure 10 years before needing the money. In other words, the fund can be nearly 100% stocks until 10 years before the target date.

And remember, you don’t need all the money on the first day your child enters college. The money can be used at any time during a typical four-year education. If your fund is down when your child is a freshmen, you can wait until later to use it.

Fund Expense Ratios

The expense ratios are higher in the funds offered by the DC 529 Plan than in the same product offered in other state plans. The higher expense ratios are in both the age-based and static funds.

For example, the DC 529 US Total Stock Market Index Portfolio has an annual administrative fee of 0.33% and a $10/year (DC resident) annual fee. The same Utah Plan fund has a 0.19% administrative fee and no annual fee.

The cost of this fund over 10 years is $571 (DC) versus $249 (Utah) assuming a $10,000 balance. That is $322 more over a 10-year period for the same product. Why would anyone spend $322 more for the same product when a cheaper one is readily available?

The other DC static funds are even more expensive than the Total Stock Market Index fund.

The DC 529 age-based funds are expensive as well. The Utah age-based funds’ cost is $270 over 10 years and for DC it is $554 again assuming a $10,000 balance. Thus, Utah’s funds are $284 cheaper than comparable DC ones. And if your balance is greater than $10,000 the savings are even more pronounced.

These are real dollars that I believe should go toward college tuition and not to DC.

In sum, DC residents should contribute the amount to get the DC tax deduction, but to look at other plans (Utah, Nevada, or New York) for contribution in excess of $4,000/year (or $8,000) for a married couple.

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