The Problem With Tax-Deductible Contributions to 529 Plans

Mar. 21, 2010 9:00 PM ET
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Contributor Since 2009

Helen Maynard, Ph.D., is the principal and founder of Affine Financial Services, a Limited Liability Company registered in Massachusetts. Her mission is to help clients develop and execute financial plans that meet their lifetime goals while minimizing the cost and associated stress. She guides clients through the "analysis paralysis" that can set in when confronted with a seemingly endless array of investment options. By breaking down the financial planning process into fundamental manageable steps, she enables clients to create their own financial path and then helps them stay on course. With a Ph.D. in Materials Science from the University Of Wisconsin - Madison, Helen worked for 15 years developing new materials and processes for semiconductor devices. She then turned her quantitative and analytical skills to her lifelong avocation of financial planning and investing. In 2008 she founded Affine Financial Systems to put her interests into practice and enable her to work with clients. She lives with her life partner and their young son north of Boston. She is progressing through the Certified Financial Planning program at Boston University. Helen is also formerly a Captain, United States Air Force.

Qualified Tuition Plans, commonly known as 529 Plans, are a great way to save for your child's education.   Investment earnings are exempt from income tax if used for college expenses.  Unfortunately, there are often high management fees to pay on top of the expense ratios of the underlying investments.

For example, if you invest in the Aggressive Growth Portfolio in Idaho's College Savings Program, you pay a total fee of 0.75% each year, of which 0.11% goes to the underlying mixture of Vanguard mutual funds.  The rest of the money (0.64%) goes to program management fees to Upromise and the State of Idaho.

Through the Idaho program, you pay more than five times the expense ratio for the privilege of having the money in a tax-advantaged account.

Why are there program management fees for 529's?

Vanguard, Fidelity and the other large financial companies offering 529's also offer tax-advantaged retirement programs like IRA's and Roth's, but do not charge an additional fee.  Surely the additional paperwork for an education fund is no greater than for a retirement fund.

They charge because they can.

Investment companies know they can charge more because individuals are motivated to invest by the tax break.  Individual investors seldom do the math to see if the tax exemption actually offsets the higher fees. The deal gets even sweeter (for the investment companies) when states offer a tax deduction for 529 contributions.

Program management fees are higher for states that offer a tax deduction

I tabulated the program management fees for the fifty state programs.  I also noted whether each state creates an incentive for residents to invest in their home state's program by offering a tax deduction for contributions.  Some states, like Pennsylvania, give a tax deduction for investing in any state's program, not just their own.

The 529 program management fees for states that offer a tax deduction are twice as high, on average, as states that do not.

Here's a snippet of the table (click on it to see the full table):

For each state, the table lists the name of the direct investment plan.   (I did not include funds sold through brokers.)  The management fee includes only fees charged by the state and/or program management company; it does not include the expense ratios of the underlying investments.  To enable comparison, for each state, I chose the age-based investment path recommended for a newborn child.

The column labeled "tax deduction" indicates whether that state offers a tax deduction for contributions made to a 529 plan.  The next column indicates whether the tax deduction is only given for investments within state.

You can scan down the column and see the effect.  The first two entries, Alaska and Alabama, do not offer tax deductions and have program management fees of 0.28% and 0.25%, respectively.  The next entry, Arkansas, does offer a tax deduction for in-state contributions, and its 529 program management fee is about double at 0.55%.

I compiled the data for the fifty states and then computed the rank-percentile graph shown in the graph below:

In the graph you can see that the median program management fee charged for a plan that does not offer a tax deduction is about 0.25%, but the fee increases to 0.45% for plans with tax incentives.

There are two plans that charge 0%, but you'll have to be a resident of either South Dakota or Louisiana to participate.

Why do plans that offer in-state tax deductions charge higher expenses?  Because they can.

The major websites that advise on 529 plans, including Morningstar and  SavingforCollege,  recommend that you choose the in-state plan if it offers a tax deduction.  When a financial company offers a 529 plan in a state that offers a tax deduction, they can count on receiving most, if not all, the investments of the residents.  They don't need to compete with other plans.  They charge higher fees because they can.

Does the tax deduction pay off?

It depends.  If you're a resident of Idaho, you can receive a state income tax deduction of up to $4,000/year for 529 contributions to the Idaho plan.  If you invest $4,000 for your newborn child and receive the maximum state tax deduction, you will save 7.8%.  However, if you invest in Illinois' Bright Start College Savings Program, you can invest in the same Vanguard index funds for the a management fee of only 0.14% instead of the 0.64% charged by the Idaho plan.  The 0.50% difference in fees, paid over eighteen years, means you pay 9% more for the same investment.  Subtract the 7.8% tax deduction you received and you've paid 1.2% more.  If you factor in the time value of money, it's probably a wash, but it's important to realize that you didn't really receive a tax break.  The tax deduction ends up benefiting the investment companies -- not you.

Most, if not all, of the state tax deductions end up in the pockets of the investment companies and not the state residents.

State legislators, take heed.  Review your state's plan.  Offer a tax deduction for contributions to any plan -- not just your state's -- and competition will drive the financial firms to reduce their fees.  Your citizens will get a better deal.

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Disclosure: No positions.

Disclosure: No positions.

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