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Saving for College: Is Proper Diversification Worth the Price? by Paul A. Merriman Publisher and Editor Every state now has a 529 savings plan for parents who want to accumulate money to send their children to college. These plans offer attractive tax breaks if the money is used to pay tuition, room and board and other qualified higher education expenses. The trouble is that most plans don’t give investors much choice in how their money is invested. We’ve found only one plan that gives investors the choices they need – and it’s more expensive than we would prefer. Parents using 529 plans face an unfortunate tradeoff between investing their money properly and keeping their costs low.
We have some suggestions. But first, a few basics about these plans. Anybody can invest in the 529 plan of any state, and the money can be used for expenses at any accredited college or university in the United States.
The main attraction of these plans is that earnings inside the account can build up free of federal income taxes. There’s no federal tax deduction for investing in a 529 plan, but in some state plans, parents can deduct their contributions for state income tax purposes.
If the money is taken out of the account for non-educational expenses, the earnings are taxable and there is usually a 10 percent penalty. That makes these plans a poor way to save for non-educational purposes.
Every 529 account is registered for a beneficiary, a young person who presumably will have higher education expenses. Money in a 529 plan is owned by the parent, not the student, so it isn’t considered the student’s asset for financial aid purposes. If for some reason the beneficiary doesn’t need the money for higher education expenses, a 529 account can be transferred to another family member, including the parent.
The tax advantages make 529 plans preferable to Coverdell education savings accounts (formerly education IRAs) and the time-honored custodial accounts under the states’ Uniform Gift to Minors’ Acts. But 529 plans have a serious drawback: Investment options are controlled by each state. And most states have very limited choices – typically way overweighted in large-cap growth stocks.
As we have told investors whenever we have the chance, we believe it’s very important to have a diversified portfolio that includes equal parts of growth and value stocks, equal parts of large and small stocks and equal parts of U.S. and international stocks.
Most 529 plans don’t come anywhere close to this ideal mix. Therefore, we were delighted to discover the details of Nebraska’s plan. This offers 22 individual mutual funds that can be mixed and matched in any combination. These funds cover the most important asset classes we recommend. What’s more, the plan covers most of those bases with low-cost Vanguard index funds.
Unfortunately, the Nebraska plan imposes higher expenses than some other 529 plans. There’s a $20 annual fee plus an overall program management fee of 0.6 percent of assets – considerably more than in other plans. For instance, the Utah plan, which we favor, charges $25 per year plus an annual expense ratio of 0.25 percent for accounts under $5,000 and 0.1875 percent for accounts of $5,000 or more.
This presents parents with a dilemma: On the one hand, they can invest in all the right assets – but Nebraska’s higher expenses will erode some of the benefit of that diversification. On the other hand, they can keep their expenses low in Utah – but they’ll give up the benefits of diversification.
The good news is that parents can invest in more than one 529 plan. We’ve put together some guidelines using the Utah and Nebraska plans. These guidelines won’t fit every individual situation, but they show that it’s possible to build a good 529 portfolio regardless of whether you have a little or a lot invested.
First, determine your equity/fixed-income allocation. We think Nebraska’s “aggressive” age-related account is a good model to follow. It shifts assets from equities to fixed-income as the beneficiary of the account gets closer to college age. This model calls for 100 percent stock funds until a child is 5. The stock allocation drops to 80 percent for ages 6 through 10, to 60 percent for ages 11 through 15, to 40 percent for ages 16 through 20 and to 20 percent for beneficiaries 21 and over. With money you know you’ll need to withdraw for expenses in a year or less, use money-market funds and similar options.
Second, determine whether you want to keep things simple, using only the Nebraska plan, or try to extract more performance from your savings by investing some money in Utah and some in Nebraska.
To keep things simple, put all your money in the Nebraska plan. Invest the fixed-income part of the portfolio in the Vanguard Short-Term Bond Index Fund (VFSTX).
The equity part of the portfolio should go into six individual funds. Put 15 percent each into Vanguard Institutional Index, Vanguard Value Index (VIVAX), Vanguard Small-Cap Value Index, Vanguard Small-Cap Index (NAESX) and 20 percent each into Vanguard Total International Stock and Fidelity Advisor Diversified International (FDVIX). Though the Fidelity fund has the word "Advisor" in its name (normally associated with load funds), no load is charged on any fund in the Nebraska 529 plan. If you're willing to add an element of complexity, you can reduce your costs and thus improve your performance. The way to do this is to use the Utah plan for your fixed-income investments (invest it in the Vanguard Institutional Index Fund Total Bond Market Fund (VITBX) and the Nebraska plan for your equity investments (using the percentages recommended above).
By using two state plans, you'll reduce your asset-based costs on fixed-income investments from Nebraska's 0.6 percent to Utah's 0.25 and 0.1875 percent rates.
More information on 529 plans, along with links to each state plan, can be found online at www.savingforcollege.com. The Nebraska plan’s site is www.planforcollegenow.com. The Utah plan’s site is www.uesp.org.
College savings plans aren’t perfect. But their tax-free growth and income should be a benefit to any parent (or grandparent) who’s setting money aside for a young person’s education.
Source: http://www.fundadvice.com
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