The Argument Against Investing in a 529 Fund

“Heresy!  Heresy!”

“Everyone knows that a 529 fund is the best way to save for your child’s education!!”

Before you throw the rotten tomatoes…

I have nothing against 529 plans.  They are a fantastic opportunity to save for your child’s college expenses.  I do, however, have a complaint against the high fees that some of the plans are charging.

In my recent study of 529 plans I came to three conclusions:

• Some plans charge exorbitant fees,
• Almost all of the plan literature is hard to wade through and compare to competing plans, and
• It needn’t be so complicated.

I set out to determine whether the high fees charge by many 529 programs offset the tax advantage.  Below is a spreadsheet I wrote to compare three scenarios.  (You’ll need to click on the image to make it readable).

On the left, I compute the amount you would have available to fund Johnny’s college expenses if you invested $10,000 on the day of his birth in a 529 that had a 6% return and 1.1% management expenses. By the time Junior is ready to don his Freshman beanie, you’ll have $24,816 to help defray his tuition bill.

In the center table, I do a similar calculation assuming you invest that same $10,000 in a taxable mutual fund.  You would then likely pay taxes every year on the capital gains, hopefully at the long-term rate.  For the index mutual fund example, I assumed a low expense ratio of 0.10%.   This approach earns you a bit more coin, $25,270 for Junior.

On the right-hand side, I computed the value of the education fund if you put the $10,000 into a taxable (non-529) portfolio account and used it to purchase stock.  Assuming that the stock increases in value at 6% per year, that it doesn’t pay dividends, and that you sell it right before junior enters college, paying only the tax at the long-term captial gains rate.  In this scenario you end up with $27,218, or $2,402 more (10% more) than if you chose a 529 fund.

The problem is that some 529 programs charge high fees.  These fees apply to the principal and earnings, whereas taxes are only paid on the earnings.   (You’ve already paid tax on the principal).  It’s not hard to see how a one-percent management fee paid each year for eighteen years can end up being more expensive than fifteen-percent paid on the earnings.

How much is too much for total expenses?

The table below shows the value of each investment would be at the end of 18 years : a 529 fund, a taxable mutual fund, or simple stock, as a function of the total expenses (management fee plus underlying fund expenses) for the 529.  The resulting investment values for a 529 total expense of 1.1% are the same as in the large table, above.  The green highlight is where the 529 yields the most money; the orange (I didn’t want to use red) highlights where the 529 is the worst investment.  The yellow region is where the 529 is better than the taxable mutual fund but worse than the simple stocks.

Not surprisingly, the 529 wins when its total expenses are low.

How does the picture change if I expect a higher rate of return on my investment?

The table below is similar to the one above, but it assumes an 8% rate of return.

If you earn a higher rate of return, then the result is less sensitive to expense fees.  The “green zone” of the table expands a bit, and the “orange zone” moves off the chart.

Are these investment options really equivalent?

No.  Holding a single stock is much riskier than holding a mutual fund.  I’m not suggesting that investing your child’s education fund in a single stock is a good choice (in fact I reccomend against it), I am merely using it as an example of the effect of taxes on the overall return.

Which 529 plans have high (and low) expenses?

Great question, and I plan to post on it soon.

Summary:

529 plans have higher fees than similar mutual funds.  These fees can erode the tax advantage of a 529.  Look carefully at the management overhead fees charged by a plan before investing.

Disclaimer: This information is for educational purposes only.  If you have questions about your particular situation, please see a financial professional.

Carnivals: This post is an Editor’s Pick at this week’s Carnival of Personal Finance.

Tags: 529 fees, 529 funds, 529 tax advantage