College Savings Plans—School Yourself Before You Invest
We all want to get our money's worth. This is true when it comes to paying for a college education—but it's also true when it comes to investing for higher education. Since 1997, investors have had the opportunity to contribute to Section 529 college savings plans, which offer tax advantages that have made them a popular investment vehicle for saving for college. The good news is that there is no shortage of college savings plans to choose from—especially given the fact that in many cases you do not need to be a resident of a state to invest in that state's college savings plan. But select with care! Virtually no two plans are the same. Doing your 529 homework is essential because:
- Contribution limits vary by state.
- State tax advantages vary from state to state and may depend on whether you are a resident of the state sponsoring the plan.
- Investment options vary greatly—from higher risk stock funds, to funds that contain a mix of stocks and bonds, to conservative investments that contain money market or conservative short-term bond funds. Most plans offer age- or enrollment-based investments that grow more conservatively over time as the beneficiary gets closer to using the proceeds to pay for college expenses. Many plans also offer static investments where assets are typically invested in a set allocation of one or more mutual funds.
- Fees and expenses vary greatly, even among plans offered within the same state.
Reason for Concern
We are issuing this Alert because we are concerned that investors may be shortchanging themselves by investing in 529 college savings plans with high fees, plans that currently do not offer them state tax benefits or both. This Alert provides an overview of 529 college savings plans, information concerning fees and expenses and a specific caution about investing in out-of-state plans. The Alert also provides you with 8 easy lessons that, if followed, will help you make smart college savings plan choices.
What are 529 Plans?
Named after the section of the federal tax code that governs them, 529 plans are tax-advantaged programs that help families save for college. There are two types—prepaid-tuition plans and college savings plans. Every state offers at least one of these types of plans. This Alert focuses exclusively on the more than 80 state-sponsored college savings plans in which money is usually invested in a group of portfolios made up of mutual funds, and withdrawals can be used for college costs, including tuition, fees, room, board, textbooks and even computers when required for college.
How College Savings Plans are Sold to Investors
There are two ways that college savings plans can be sold to investors:
- "Direct-Sold College Savings Plans" in which you buy an interest in the college saving plan directly from a broker-dealer on behalf of the state, the state that sponsors the plan or from the plan's program manager, with no sales person involved; and
- "Broker-Sold College Savings Plans" in which you buy an interest in a college saving plan through an investment adviser, brokerage firm or bank, generally paying a sales load or fee.
The brokerage community has done a fine job of educating investors about the benefits of 529 investing, but investors should take heed:
- Some brokerage firms and advisers offer only one or a very limited number of 529 plans. The options may not include your own state's college saving plan and may not provide you the opportunity to invest in college savings plans issued by other states, even though those other 529 plans may have lower sales loads, lower expenses or may provide state tax advantages that are not available when invested in the plan being offered.
- Broker-sold plans often contain sales loads and higher fees and expenses than direct-sold plans.
Don't Overlook State Tax Advantages.
Federal tax advantages are a major benefit of investing in 529 plans. When you invest in a 529 plan, your earnings grow tax-free. Furthermore, qualified withdrawals are also tax-free when used for qualified education expenses.
While federal tax advantages are standard to all college savings plans, state tax treatment of 529 plans varies from state to state and can be a factor in deciding which plan to select. In over 30 states, contributions are either tax deductible if you're a resident of the state sponsoring the 529 plan or you can receive a tax credit for contributions. In five of those states—Arizona, Kansas, Maine, Missouri and Pennsylvania—you can claim a state tax deduction from any 529, regardless of its location. Deductions and tax credits vary from state to state. For example, Colorado currently allows residents to deduct the entire amount of their contribution to their in-state plan for each beneficiary, up to the amount of their annual gross income. Rhode Island, on the other hand, allows only a $1000 deduction in total for joint filers and $500 for single filers. Many states also follow the federal tax lead of allowing earnings to grow tax-free and imposing no state tax on qualified withdrawals from in-state and out-of-state plans.
States Offering Tax Deductions or Credits to In-State Investors
|District of Columbia||Missouri||South Carolina|
|Indiana||New York||West Virginia|
Several states impose taxes on qualified withdrawals from out-of-state plans and a few tax earnings on out-of-state plans. In an effort to keep money in its own state plan, New York even "recaptures" state income tax deductions that were given to state residents who move money from the New York college savings plan to a college savings plan in another state.
In many cases, the smart move is to check out a plan in your home state—especially if your state allows you to deduct some or all of your 529 contributions, but always do the math to evaluate the value to you of any state tax benefit.
Remember: the tax rules that apply to college investing options are complicated. Before investing, you may want to check with your tax advisor about the tax consequences of investing in college savings plans or read Internal Revenue Service Publication 970, Tax Benefits for Higher Education.
Don't Flunk 529 Investing
As we found, investors can be persuaded to put money in a 529 college-savings plan that offers them no in-state tax breaks. Here's how it can happen:
A couple from Colorado receives a call from a broker who recommends a 529 Plan in another state. The couple invests $10,000. The plan may have similar fees and expenses to their home-state plan, and it offers the couple the same federal tax incentives available to all 529 investors. But it DOES NOT give them any state-tax benefits. In Colorado, those benefits are substantial: they are fully deductible up to the contributor’s adjusted gross income. Colorado’s income tax is a flat 4.63 percent of federal taxable income, so a $10,000 investment in an out-of-state plan meant missing out on $463 worth of Colorado tax incentives—money that could itself be invested to pay for college expenses.
NOTE: There may also be instances where a plan offers in-state tax breaks which are offset by higher plan fees or poor investment performance.
Compare Fees and Expenses
All 529 college savings plans contain fees and expenses. These costs not only vary among 529 plans but also can vary within a single 529 plan. Fees may include: enrollment charges, annual maintenance fees, sales loads, deferred sales charges paid when you withdraw your money, administration and management fees (often called the expense ratio) and underlying fund expenses.
It bears restating that broker-sold plans often cost more than direct-sold plans. Typically, these additional costs take the form of front-end sales loads or other fees associated with share classes (described below), and annual distribution fees, including service fees that compensate the financial professional, who provides guidance in selecting a plan and managing your savings.
Be Alert to Share Class Costs
The decision process is made even more challenging because some broker-sold college savings plans, like some mutual funds, have different share classes. Often referred to as Class A, B, or C shares; each class has different fees and expenses. Inspect the offering document carefully with an eye to whether a particular college savings plan offers more than one class.
College Savings Plan Share Class Costs Comparison Chart
|Class A||Class B||Class C|
|Front-End Load||Initial sales charge. Can be reduced or eliminated by breakpoint discounts.||None.||None.|
|Contingent Deferred Sales Charge (CDSC)||None.||Declines over several years.||Typically, lower CDSC than Class B that is eliminated after one year.|
|12b-1 Fees||Typically, lower than Class B and C shares.||Typically, higher than Class A shares.||Typically, higher than Class A shares.|
|Converts to Class A Shares||N/A.||Convert to Class A shares after several years, thereafter reducing expenses.||No. Annual expenses remain at Class C level.|
In many cases, in-state residents can avoid these extra expenses by buying the plan directly from the state. Some college savings plans even allow non-residents to avoid these extra expenses by buying shares in a direct-sold plan. However, if you buy directly from the state or its program manager, you won't receive the assistance of a broker or financial professional, which may be important to you.
In sum, take the time to research all fees and expenses and carefully compare plans. Costs can add up, diminishing any tax incentives a 529 plan may offer.
Use FINRA's 529 College Savings Plan Expense Analyzer
Because fees and expenses can vary widely from plan to plan, FINRA has developed a tool to help you compare how these fees and expenses can impact returns. The analyzer is designed to work with most college savings plans. It explains the various fees and provides guidance about where to find them in 529 disclosure documents. It also provides prompts that help ensure the best possible comparison between plans. Try it now.
Be Wary of 529 Plan Ratings.
Several Web sites and publications rate 529 plans and some states tout the rating their plans received. Make sure you understand the basis for these ratings. Some third-party ratings systems appear to give little weight to state tax benefits or low expenses.
Here are 8 lessons that, if followed, will help you make smart college savings plan choices:
- Start with your home state first when looking for a college savings plan. Pay special attention to state tax breaks and fees that are waived or lowered for in-state residents.
- Consider the plan's investment options.
- Be aware that broker-sold plans are generally more expensive than direct-sold plans. If you're comfortable going it alone, you can often save money investing in a direct-sold plan.
- Remember that one size does not fit all. Some brokerage firms and advisers offer only one or a very limited number of 529 plans and do not provide investors the opportunity to invest in college savings plans issued by other states, even though those other 529 plans may have lower sales loads and lower expenses, may provide state tax advantages that are absent from the plans being offered, or may have better investment options.
- Ask questions. If you are investing on your own, call the toll-free numbers posted on the state-sponsored sites. If you are working with a broker or financial professional, don't hesitate to ask:
- How many different college savings plans do you offer?
- Can I claim a state-tax deduction on contributions to the college saving plan you're recommending?
- How much will I pay in fees and expenses?
- Do the fees and expenses outstrip any tax savings I may achieve?
- Compare expenses, especially if your state offers both broker-sold and direct-sold plans and if you are considering investing in an out-of-state plan.
- Independently verify sales information you receive by thoroughly reading the official disclosure documentation.
- Make sure the investment meets your objectives and that you understand and are comfortable with the risks, costs, and liquidity of the investment. Never invest in a product you don't understand.
Consider a Variety of College Savings Options
Finally, do not limit your research to college savings plans alone-there are a number of other tax advantaged college savings options you can consider. These include:
- Prepaid Tuition Plans
- Educational Saving Accounts
- Custodial Accounts
- Savings Bonds
You can learn about college savings plans and each of these other college savings options in FINRA's Smart Saving for College learning center.
For more information on 529 plans visit these links and Web sites:
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