The benefits of staying close to home may not be as great as they seem.
By Marta Norton | 04-16-08 | 08:00 AM | Email Article

With 529 college-savings plans, there's an advantage to staying close to home. States often offer tax deductions to residents who contribute to their own state's plan, but most will let you invest in another state's plan only using aftertax dollars. That's an argument in favor of sticking with your own state's plan, to be sure, but the value of the tax incentive may be far outweighed by other factors. After taking other plan features into account, you might find it pays to shop out of state. In this article, we'll discuss what college savers should look for when determining whether to stay in-state or search for greener pastures elsewhere.

Marta Norton, CFA, is an investment manager with Morningstar Investment Management.

Pinch Pennies
As dull as it sounds, expenses matter. Morningstar research has shown expenses are the best predictors of long-term returns, so the cheaper the fund, the better the chance it will outperform. This makes intuitive sense. There's no guarantee that the market will favor a fund's strategy or that the manager will make the right calls, but how much you pay will be a sure thing.

In the 529 world, fees are even more important. Not only are you paying the underlying fund expenses, 529 plans tack on added administrative and management fees, not to mention the commissions you'll pay if you're investing through a broker. After summing it all up, investors can lose quite a bit of their returns to expenses. Consider, for example, the Nebraska AIM College Savings Growth Allocation Fund 529 Portfolio. Investors pay 1.61% in total annual asset-based fees, along with a sales charge and a $25 annual account fee. College savers invested in a similar growth-focused portfolio at the Virginia CollegeAmerica 529 College Savings Plan would also pay a sales charge, but they would pay only a $10 annual account fee and 0.80% in annual asset-based fees. That gives investors in the Virginia's plan a big head start, and the money saved from lower expenses will compound over time.

Stocks, Bonds, and Everything in Between
The structure of your portfolio is also something to carefully consider, particularly because many studies demonstrate that asset allocation is one of the primary drivers of returns. Of course, some investors can handle more volatility than others, so there's no one-size-fits-all solution, but there are some general rules of thumb. First, diversification matters. Some plans, including Florida's College Investment Plan, offer very little in the way of international or small-cap exposure. That not only limits your potential return, it also makes your portfolio too reliant on domestic large-cap stocks. To see how your state's plan stacks up in the asset-allocation department, take a look at this article by my colleague David Kathman. He uses target-date retirement funds to offer some guidance as to the right mix among asset classes.

Your time horizon is another important consideration. The more time you have before your beneficiary reaches college age, the better you will be able to handle the fits and starts that come from more-aggressive asset classes. So, it makes sense to stick mostly to the more volatile, but higher-returning, equity market early on. Conversely, if you have only a few years to save until college, your portfolio may not have time to recover from a painful drop in the market. Thus, sticking more assets in bonds is typically a more sensible asset allocation, because bonds tend to offer a steadier ride than stocks. It's a straightforward enough strategy, but not every state offers reasonable transitions between stocks and bonds. Wisconsin EdVest College Savings Plan is one culprit with an abrupt shift between the two. Because that plan is the better of Wisconsin's 529 plans, Badger State residents might want to check out what's available elsewhere.

Underlying Funds: The Bread and Butter
A cheap 529 plan with a reasonable asset allocation can still disappoint if it isn't filled with good underlying funds. And while some 529 plans are chock-full of worthwhile offerings, there are plenty with the lackluster variety, and lots of dogs, too. So how do you determine whether your state is offering you best-of-breed or runners-up?

Investigate manager skill at the mutual funds, for starters. If the management team has proven itself in many different market environments, it makes sense to have more confidence in the fund. Also, look for sensible strategies. Given that the key is a well-diversified portfolio that can handle the market's fits and starts, you'll want to see most funds offering broad-market exposure to major asset classes, instead of lots of specialty options that won't play a major role in your portfolio. And, of course, low-priced funds are critical.

Taken together, good management, prudent strategies, and low fees can have a big impact on your portfolio's return. Case in point: A $5,000 investment in Ohio's broker-sold Putnam CollegeAdvantage Savings Growth Portfolio, which relies on mostly mediocre funds with unimpressive track records, would have grown to $8,261 since mid-2003. The same investment in a similarly constructed portfolio from Virginia CollegeAmerica 529 College Savings Plan, which sticks with proven management teams from American Funds, would have climbed to $9,768 over the same period. For most people, that difference more than makes up for the tax savings from deductible contributions.

Don't Forget
Everyone's financial situation is different, so be sure to carefully consider your tax situation and college-saving goals before making your decision. And if you're curious how the 529 competition stacks up, check out 2008's Best and Worst 529 Plans.

A version of this article appeared on March 4, 2008.

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