Nearly two-thirds of 529 accounts leave big money on the table. Here's why

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Amid soaring costs for higher education, 529 college savings plans are sold as a reliable way to fund schooling for a child or grandchild.

But more than half of the tax-advantaged accounts underperform, according to new academic research.

The drain comes from high fees and tax savings that don't materialize, according to a National Bureau of Economic Research study last month. States' different tax systems and varying deductions or credits offered for account contributions, along with the openness of plans to out-of-state residents, create a tangle of variables in the equation of whether a plan is worth it.

Many of the millions of investors who had socked $425 billion into 14.9 million accounts by the end of 2020 appear unaware of the differences in the complex plans. Six in 10 accounts are expected to lose 9% of their after-tax value over 18 years, the age at which most students enroll in college, the study by three researchers at the University of Pennsylvania's Wharton School found. 

In other words, those 529 account holders can expect to miss out on $37.7 billion of gains.

The drain is due to the myriad ways in which states administer plans and savers' confusion about how they work. Maine, for example, offers multiple matching grants for in-state residents. Meanwhile, Florida offers a lower-cost plan relative to California's, but the Sunshine State's plan is only available to in-state residents.

Look afield
The takeaway for would-be buyers of 529s and their financial advisors: Look beyond your state of residence for a plan. 

"The optimal plan for one household may be located in its home state, due to a combination of low fees and tax savings," the study said. Meanwhile, "the optimal plan for a household in another state may be an out-of-state plan, due to high fees and lack of tax-savings for its home-state plan."

Investors and their advisors typically approach 529 plans from the perspective of whether an account makes economic sense based on a child's age and family's attitude toward college, said William F. Spencer, a wealth planner at Crestwood Advisors in Westport, Connecticut. Buyers then have to sort through the jumble of fees and tax consequences. 

"For those without state benefits, investments and fees become most important," Spencer said.

Importantly, a household doesn't have to live in the same state whose plan it buys. So a Colorado resident can buy a California plan. And many states offer more than one plan. Data reflecting that flexibility and variation are what allowed researchers James Li, Olivia Mitchell and Christina Zhu to conduct their study.

Investors have bought more plans since 2020, the final year in the NBER study. Some 15.9 million accounts held more than $420.5 billion as of last June, a growth of more than 50% in the number of accounts since 2009, according to the National Association of State Treasurers.

How 529s work
Sponsored by states, 529s, which are named for a section of the tax code, come in two flavors. One allows the donor to hedge against inflation by prepaying tuition and related expenses, typically at participating public and in-state colleges and universities. The other allows the account holder to open an investment account with mutual funds and exchange-traded funds to save for a beneficiary's educational costs at any institution.

All 50 states, including the District of Columbia, contract with a record keeper, asset management company, bank or government agency to set a menu of investment options and administer the accounts. That "program manager" is typically an investment manager — Vanguard, Capital Group's American Funds and Fidelity Investments are the top three of 529s. Program managers aren't subject to the fiduciary responsibilities to act in a client's best interest, so some plans may contain high-cost funds.

Contributions to 529 plans are funded with dollars on which taxes have already been paid, so they don't generate federal tax deductions. Money in the accounts grows tax-free, with withdrawals used for tuition and qualified expenses also not subject to federal tax. 

While 529 plans don't have annual contribution limits, contributions are considered completed gifts by the Internal Revenue Service. This year, a donor can give a beneficiary up to $17,000 without it cutting into their federal gift and estate tax exclusion of $12.92 million, the level at which the 40% estate tax kicks in. Alternatively, a donor can "superfund" a 529 account by making the equivalent of five years' worth of contributions at once.

Jonathan Thomas, a private wealth advisor at LVW Advisors in Rochester, New York, likes 529 plans because they move money out of a donor's taxable estate. 

"This is particularly advantageous for grandparents with substantial assets who have multiple children and grandchildren," he said. 

Nearly 1 in 4, or 22.8%, of 529 account funders make at least $150,000 a year, according to recent data from ISS Market Intelligence.

Tax puzzle
But choosing the right plan involves piecing together a puzzle involving tax rates in your state and the plan state, along with fees and whether either or both states offer credits or deductions for contributions. 

"It pays to do your homework," says BlackRock.

As of 2020, the NBER study found, 28 states, including the District of Columbia, offered tax deductions or credits for contributions to in-state plans. Seven states, including Arizona, Ohio and Pennsylvania, offer tax "parity," in which contributions to a plan in any state can earn that state's deduction. Seven states, including California and North Carolina, offer no tax benefits for contributions. The remaining nine states don't charge state income taxes.

Residents of 28 states including Colorado, North Carolina and Texas would be better off skipping their state plans and investing in California's Scholarshare College Savings Plan, the study found. California lets investors in other states open accounts, but it doesn't offer a state deduction or credit for contributions. 

Minus those perks, its plan is still worth it, the report found, citing "lowest asset-based fees" and no additional fees for maintenance, application or cancellation.

Many states offer plans that are sold both directly — through the plan sponsor — and through financial advisors. Direct plans are sold by a state-based financial institution to DIY savers, who choose the underlying investments. By contrast, advisor-sold plans are sold by an investment firm that typically offers higher-priced actively managed funds for an account. 

The study defined a "suboptimal home-state investment" as one in which an adult opens a 529 in-state account in their state of residence when the household could earn a higher expected return by instead opening an out-of-state account.

In 2020, the study said, $281 billion of assets and 8.9 million open accounts were held in suboptimal home-state accounts, representing 66% of assets under management and 60% of open accounts that year. The researchers assumed that an account was opened at a beneficiary's birth with a $10,000 contribution and had an 18-year investment period with gains compounding at 5%. Accounts had an average balance of $28,500 after 18 years.

When a state grants a tax deduction only for contributions to in-state plans, it creates a higher payoff that can offset the higher investment fees relative to the cheapest out-of-state plan, the study found. Eighteen of the 28 states with tax deductions have optimal home plans. 

Of these 18 states, 14 have multiple plans, and the optimal home-state plan is consistently the direct-sold plan rather than the advisor-sold plan offered by the same state. Direct-sold plans almost always have lower fees than advisor-sold plans, 0.34% vs. 0.84%, according to Morningstar.

In a challenge to the wealth management industry, the study's authors said that "investors who chose suboptimal plans are more likely to be less financially literate and thus seek costly financial advice. 

"In states with higher levels of financial literacy, households invest less in suboptimal plans compared to the optimal plan," it found.

Last November, Morningstar rated advisor-sold plans in Maine, New Jersey, South Dakota and Wisconsin as not worth it.

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