I was asked recently whether it wise to contribute more than the state tax deduction amount of $4,000 to the Virginia 529 College Savings Plan. Virginia maintains two distinct plans:
- The InVest 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 Plan, which offers semesters of in-state Virginia Public institutions 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 private Virginia institutions and out-of-state institutions as well.
They are different programs. The discussion below focuses on the InVest Plan. A future blog will discuss the merits of the PrePaid Plan. Virginia also offers College Savings and College America plans. Both of these plans are bank account funds and not investments – suitable for when you open an account and need the money right away and can’t take any investment risk.
I discussed a similar question about the District of Columbia 529 Plan a few months ago. In short, the DC 529 College Savings Plan is an expensive plan. I suggested that the account owner contribute just enough to receive the maximum annual DC 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 that compared DC Plan funds.
I wondered whether the Virginia InVest Plan was better than the DC Plan such that Virginia residents would not have to invest out-of-state to get a better selection of funds at a lower expense rate. In short, it is, but with a few caveats that I point out below.
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.
Virginia InVest Plan’s Age-Based Funds
I compared the Virginia 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, ranks the Utah (Utah Educational Savings Plan) as a good college savings plans for out-of-state savers due to their low costs and varied investment choices.
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 grows up, 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 more 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 Virginia InVest Plan are slightly more expensive (higher expense rate) than the Utah Plan.
For example, the most aggressive age-based fund in the Virginia InVest Plan is the Rappahannock Fund. This fund is aimed toward children that are age 0-3. It has an expense rate of 0.74% and it has an asset allocation of 80% stocks / 20% bonds. This fund’s asset allocation will change to a 70% stock / 30% bond portfolio for the January 2018 – December 2020 time period. Three years after that, the fund will shift to a 60% stock / 40% bond asset allocation.
The comparable Utah fund (the Age-Based Moderate 0-3), has a fee of 0.219%. That 0.521% savings on a $8,000 annual contribution over an 18-year period can mean an additional $8,000 in available funds. Because fees are netted against the fund’s return, it is not surprising to see that the investment performance of the comparable Virginia age-based funds has been slightly lower by nearly the same percentage compared to the comparable Utah funds.
Static Investment Funds
A quick look at Virginia’s and Utah’s static investments shows that Virginia has some of the lowest cost static investments. Static fund maintain the same asset allocation over time.
For example, the Virginia Aggressive Allocation Fund maintains an 80% stock / 20% bond asset allocation, which is comparable to the asset allocation in the age-based Rappahannock Fund, but has a lower expense rate. The expense rate for this fund is 0.32%.
These static funds have the same asset allocation as the age-based portfolios in terms of asset allocation, but at a lower expense rate. Its lower because there is no automatic rebalancing at three-year intervals to make the fund more conservative.
The performance of the static funds are not comparable to the age-based funds because the Aggressive Allocation Fund uses a Vanguard Fund while the age-based funds are compilations of other widely available funds. Because the only thing you can really control is your fees and asset allocation, I lend more credence to low fees and disregard if an actively managed fund has a better year. Over the long-term low fees matter most.
The Virginia Plan also offers a subset of Vanguard Index funds with rock bottom expense fees in each asset class (large cap stocks, emerging markets, etc.). These funds are for the do-it-yourself crowd. For example, the Vanguard Total Stock Market Fund has a 0.19% expense rate and the Vanguard Total Bond Market Index Fund has an expense rate of 0.20%. So these offerings are comparable to the ones offered in the Utah Plan.
My recommendation for Virginia residents is not to invest out-of-state. There is no “magic” behind rebalancing every three years to have more conservator investments, which is the approach of the age-based funds. Indeed, it may be premature or doing it at the wrong time.
Rather than using the more expensive age-based funds, one approach to consider is to invest in the static Aggressive Allocation Fund (or any of the other static allocation funds) until the child is age 10. At that time you can examine whether it is time to move to a more conservative approach. It depends on your risk tolerance and your child’s college expectations.
Another approach is to use the low-cost Vanguard funds in the Virginia InVest Plan to create your own portfolio with an appropriate asset allocation. Consider keeping this allocation until you have a better handle on when your child will need the money and how the market is performing. For example, as your child enters high school it may be appropriate to readjust the portfolio depending upon market performance and other factors such as other income you can use to fund their college education.
In sum, the Virginia InVest Plan offers low-cost static allocation and building block funds that you can use for your college savings beyond the maximum allowable state income deduction.