In a way, it’s too bad that relying on the luck of the draw is no way to craft an investment strategy, because I happen to have had more than my fair share of winning hands in life so far. Of course I place my family at the top of that lucky-list. But one of my most fortunate career breaks came during my past role as a Morningstar analyst when I had the chance to become well-informed about 529 college savings plans.
When my eldest child was but a newborn, I was Morningstar’s lead analyst for 529 plans. I led a team of analysts to cover 80+ 529 college savings plans, which included in-depth interviews with representatives from the states that sponsored these plans as well as the investment companies that administered the investments within them. This work culminated in Morningstar’s 2009 report, “The Best and Worst 529 College-Savings Plans,” which turned out to be Morningstar’s top-read article of the year!
In short, the gig afforded me the good fortune to understand 529 plans from the inside out — the good, the bad, and the ugly. It’s also been helpful in giving my wife and me a better-than-fighting chance to fund our own children’s higher education aspirations, just in case their innate brilliance doesn’t score them all-expense-paid scholarships to the institutions of their choice.
But before we get ahead of ourselves (as we parents tend to do!), let’s begin at the beginning. What is a 529 college savings plan?
529 Plan Overview
529 college savings plans were born in 1996, after the IRS created Section 529 of the Internal Revenue Code. So that explains the “529” bit. The idea was to help families save for college by offering tax incentives that are similar (but not identical!) to Roth IRA individual retirement accounts. At the federal level, 529 plan contributions are made with after-tax dollars, similar to Roth IRAs. Earnings grow tax-deferred, and when it comes time to cut that check to Harvard (hey, here’s to wishful thinking), withdrawals to pay for qualified education expenses–such as tuition, room, and board–come out federally tax-free. Unlike Roth IRAs, some 529 plans offer additional tax breaks and incentives, such as state income tax deduction on contributions, and matching contributions for residents who qualify. Today, almost every state offers at least one 529 plan.
From there, as with any tax-favorable program, things get a lot more complicated when determining which plan, if any, makes the most sense for you and your family’s personal college savings plans. (I say, “if any,” because there can be circumstances when the tax benefits are not sufficiently compelling to warrant a 529 plan investment to begin with.)
State Loyalty Not Required
It’s important to know that you do NOT have to invest in your own state’s 529 plan; you are free to choose any plan, from anywhere. And yet, I see too many investors turn to their own state’s plan, even when it may be overpriced or poorly constructed. It may be out of a sense of loyalty, or maybe it’s the familiarity bias. (If you’ve been reading my blog lately, I’m big on behavioral biases and how they trip up investors.) After being exposed to extensive local ad campaigns, it may seem as if your state plan is the only way to go.
It’s not. There’s nothing wrong with rooting for your home sports team. I’m a big fan of Michigan State myself, and I pay my state taxes as willingly as the next guy. But when it comes to your child’s higher education, we advise that you cheer for the 529 plan that is expected to help you make the absolute most of your hard-earned savings.
So, given that you are not only free but encouraged to shop around, how do you go about comparing and contrasting those 80+ 529 plans available to you? Stay tuned for my upcoming post to learn more.
For more information or to set up a consultation, contact Pathway Financial Planning at or email firstname.lastname@example.org.