Larry Glazer, a managing partner at Mayflower Advisors in Boston, has a message to families eyeing 529 college savings plans. An in-state plan may not be best.
According to the financial aid website, FinAid.org, 34 states and the District of Columbia offer a state income tax deduction for residents who invest in their 529 college savings plan. While the deduction is worth examining, experts say that it’s only one factor in choosing the right plan. Here’s how to compare 529 plans that offer an in-state deduction with those that don’t.
Bone up on tax benefits
If your state offers a tax break, researching that plan is a good place to start, says Glazer. “(Families should) be aware of what the state tax benefit is because it might not be as significant as they think,” he says.
In New York, for example, the maximum annual deduction is $10,000 for joint filers. Taking into consideration the state’s maximum income tax rate of 8.97 percent and subtracting the state tax deduction from the federal deduction, Glazer says that a $10,000 tax deduction only comes out to a savings of about $500 for families.
Even among states that do offer an in-state benefit, the amount of the benefit varies from an $87 per beneficiary tax credit for single filers in Utah to a $20,000 deduction for joint filers in Oklahoma and Illinois. In Illinois and Oklahoma, the benefit is contingent on the amount families can save. While an extra $500 sounds like a great deal, the reality is that few families can contribute the $10,000 necessary each year to get it.
For low savers, the benefit will be much less. According to a report by the investment research firm Morningstar, the average benefit among states that offer income tax incentives for 529 plans is $87 for every $1,000 invested by families. For high savers who can put away five figures in college savings per year, a few hundred extra is substantial savings, even more so if those funds are re-invested in the 529 plan. But, investors might be able to bank more in the long run by going with an out-of-state plan that offers better performance.
In-state tax deductions matter most to families who plan to save at or below the deduction phase-out limits and for those who have a shorter saving time frame, says Glen Merritt, a Certified Financial Planner with Raymond James & Associates in Atlanta.
“(For longer-term savers), the investment decision is more important than the tax decision,” he says, adding that families who invest in a 529 plan for 10 years will reap greater financial gains or take bigger losses than families who invest for just five years.
Instead of choosing a plan based on whether it offers a tax benefit, Merritt advises families with young beneficiaries to first research several plans’ overall performance, paying close attention to how the 529 plan has performed over the past three years. Then, they should weigh whether the in-state tax benefit is most lucrative in the long run.
In some states, investors don’t have to choose between in-state tax benefits and better performing out-of-state plans. In Arizona, Kansas, Maine, Missouri and Pennsylvania, investors can receive a state income tax deduction regardless of whether they invest in their state’s college savings plan or a different 529 plan.
Make room for fees
A generous tax deduction won’t amount to anything if your account is eaten up by high advisory and maintenance fees. Before factoring in a state tax benefit, families should look for plans that come with a low fee structure, says Lynne Ward, executive director of the Utah Educational Savings Plan.
“Look for plans that don’t charge an annual fee,” Ward says, adding that the Utah state 529 plan has no an annual fee for in-state investors. And, out-of-state investors can have that fee waived if they opt to receive their quarterly statements online.
“Typically, adviser-sold plans are more expensive than direct-sold (plans), so be careful about the fees,” Ward says.
Ward adds that families can assess how pricey a plan is by asking for the program’s expense ratio, or the percentage of your investments devoted to paying fees associated with running the plan. For direct-sold plans, anything above 0.35 percent (35 basis points) is too much.
Of course, you don’t have to settle on just one 529 plan. “My clients don’t have all of their money in one 529 plan,” says Dan Yu, a Certified Financial Planner and director at EisnerAmper LLP in New York. “Diversification is important, and the best plans frequently aren’t in clients’ home states.”
To get both performance and tax benefits, Yu advises clients to open an account in their home state, max out the benefit and invest any additional savings in a higher performing out-of-state 529 plan. This tactic not only maximizes tax incentives, it also gives clients a backup strategy in case one state’s plan takes a nose dive.
“Investors should be asking, ‘How much can I save over time? What is it costing me? Is it performing above or below average over time?'” Yu says. “The tax benefit is not the end driver.”