Updated: 529 Savings Plans—School Yourself Before You Invest
Update: The Tax Cuts and Jobs Act of 2017 brought important changes to 529 savings plans, which can now be used to pay for K-12 tuition, up to $10,000 per taxable year per designated beneficiary for all 529 savings plans. We are updating and reissuing this alert to highlight these changes, and to remind investors to closely consider both their state of residency and the applicable fees—including fees associated with share classes—when making 529 investment decisions.
529 savings plans are named after Section 529 of the Internal Revenue Code. They include prepaid tuition plans and savings plans and, more recently, 529 A or "ABLE” programs that offer tax-deferred incentives to help pay for disability-related expenses.
This Alert focuses exclusively on 529 savings plans. Also, see our 529 Investor Tips.
529 Savings Plan Basics
529 savings plans offer a tax-advantaged way to save for education. You don't get a tax break on contributions, but earnings accumulate on a tax-deferred basis, and withdrawals are not taxed by the federal government when used for "qualified higher education expenses.”
Qualified higher education expenses include tuition, fees, books, certain computer-related expenses and certain room and board. In addition, up to $10,000 during the taxable year may be withdrawn from your 529 savings plan account for tuition expenses in connection with enrollment or attendance at an elementary or secondary public, private or religious school subject to certain conditions.
The Municipal Securities Rulemaking Board (MSRB) governs sales or underwriting of 529 plans. As such, brokerage firms that sell or underwrite 529 plans must be registered with the MSRB. MSRB rules are enforced by FINRA, the Securities and Exchange Commission and bank regulators including the FDIC, Office of the Comptroller of the Currency and the Federal Reserve.
Do Your Homework
There is no shortage of 529 savings plans to choose from. Almost every state offers one—and in many cases, you do not need to be a resident of a state to invest in that state's 529 savings plan. But select with care. Virtually no two plans are the same. Doing your 529 homework is essential.
- Contribution limits vary by state.
- State tax advantages and other state benefits vary from state to state and may depend on whether you are a resident of the state sponsoring the plan.
- Investment options vary greatly—from higher risk stock funds, to funds that contain a mix of stocks and bonds, to conservative investments that contain money market or conservative short-term bond funds or certificates of deposit.
- Most plans offer age- or enrollment-based investments that become more conservative over time as the beneficiary gets closer to making a withdrawal from the plan to pay for qualified educational expenses.
And Be Aware: Fees and expenses vary greatly, even among plans offered within the same state, as many states offer one or more 529 savings plans.
How 529 Savings Plans Are Sold to Investors
529 savings plans are sold to investors in two ways:
- Direct-sold savings plans: you buy an interest in the savings plan directly from the state that sponsors the plan, or from the plan's program manager, with no sales commission; and
- Advisor-sold savings plans: you buy an interest in a savings plan through an investment professional such as a broker or registered investment adviser, generally paying a sales commission.
In evaluating 529 savings plan choices, investors should understand that advisor-sold plans often include sales loads and higher fees and expenses than direct-sold plans. In addition, some brokerage firms and advisers offer only one or a very limited number of 529 plans. For example, a broker may not include your own state's 529 savings plan as a sales offering, and may not provide you the opportunity to invest in 529 plans issued by other states. This means you could be missing out on 529 plans with lower sales loads, lower expenses or state tax advantages.
That said, direct-sold plans also require some homework. These plans vary and, while generally less expensive, may offer more limited investment options than broker-sold plans. Information provided will be limited to the state plan, and will not include investment advice or recommendations.
Don't Overlook State Tax Advantages
Federal tax advantages are a major benefit of investing in 529 plans—but state tax treatment of 529 plans varies from state to state and can be a factor in deciding which plan to select. In over 30 states, contributions are either state tax deductible or you can receive a state tax credit for contributions if you're a resident of the state sponsoring the 529 plan. Some states even offer a state tax deduction from any 529 savings plan, regardless of its location. Deductions and tax credits vary from state to state so you will have to do your homework and consider the tax advantages offered before you choose a 529 savings plan. Beware of potential recapture of the state tax deduction if you rollover your 529 savings plan to a 529 savings plan offered by another state, or if you make a non-qualified withdrawal.
The smart move is to first check out a plan in your home state—especially if your state allows you to deduct some or all of your 529 contributions—but always do the math to evaluate the value to you of any state tax benefit.
Remember: the tax rules that apply to 529 investing options are complicated. Before investing, you may want to check with your tax advisor about the tax consequences of investing in 529 savings plans or read Internal Revenue Service Publication 970, Tax Benefits for Education.
Compare Fees and Expenses
All 529 savings plans have fees and expenses. These costs not only vary among 529 savings plans but also can vary within a single 529 savings plan. Fees may include enrollment charges, annual maintenance fees, sales loads, deferred sales charges paid when you withdraw your money, administration and management fees (often called the expense ratio), and underlying fund expenses. To that end, it is a good idea to review the offering document for the 529 savings plan carefully with an eye to fees.
It bears restating that plans sold by brokers or advisers often cost more than direct-sold plans. Typically, these additional costs take the form of front-end or annual sales loads or other fees associated with share classes (described below), and distribution fees, including service fees that compensate the financial professional, who provides guidance in selecting a plan and managing your savings.
Be Alert to Share Class Costs
The 529 decision process doesn't end here. You also should consider that plans sold by investment professionals have different share classes, most commonly Class A and Class C shares, which have different fee structures.
|Class A Shares||Class C Shares|
|Typically impose a front-end sales charge but charge lower annual fees compared to Class C shares.||Typically impose no front-end sales charge but impose higher annual fees than Class A shares.|
Since the aggregate costs of C shares tend to exceed the aggregate costs of A shares over time, the longer you plan to hold your securities, the more expensive C shares may become. For this reason, carefully consider the timeframe in which you intend to hold your securities before making a withdrawal from your 529 savings plan to pay for qualified educational expenses.
FINRA notes in its 529 Regulatory Notice that when assets are expected to be invested for more than six to seven years—for example, in a 529 plan purchased for the future college expenses of a beneficiary younger than 12—A shares may be the more cost-effective choice. As with other fees, refer to the plan's offering document for share class information. It will state whether the particular plan offers more than one class, and also provide the cost structure of each share class.
Share class issues are sometimes not a consideration with direct-sold plans. In many cases, in-state residents can avoid these extra expenses by buying the plan directly from the state. Some 529 savings plans even allow non-residents to avoid these extra expenses by buying shares in a direct-sold plan. However, if you buy directly from the state or its program manager, you won't receive the assistance of a broker or financial professional, which may be important to you.
In sum, take the time to research all fees and expenses and carefully compare plans. Costs can add up, diminishing any tax incentives a 529 plan may offer.
Use FINRA's 529 Expense Analyzer
Because fees and expenses can vary widely from plan to plan, FINRA has developed a tool to help you compare how these fees and expenses can impact returns. The tool is designed to work with most 529 savings plans. It explains the various fees and provides guidance about where to find them in 529 disclosure documents (users must input the fee data). The calculator also provides prompts that help ensure the best possible comparison between plans. Try it now.
Be Wary of 529 Plan Ratings. Several websites and publications rate 529 plans and some states tout their plans rating in promotional materials. Make sure you understand the basis for these ratings. Some third-party ratings systems appear to give little weight to state tax benefits or low expenses.
- FINRA Investor Information: Saving for Education
- MSRB Investor Information: 529 Plans and ABLE Programs
- SEC Investor Bulletin: 10 Questions to Consider Before Opening a 529 Account
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