Balance tax savings against quality of plan.
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By Christine Benz | 10-25-10 | 06:00 AM | Email Article

Are you shopping for a 529 college-savings plan for a child or grandchild, niece or nephew? If so, you may feel like you need to go back to college yourself . That's because the 529 landscape is complicated--needlessly so, in my view. Not only does nearly every state offer its own plan (or plans) featuring different investment options and cost structures, but it's also up to each state to determine the tax breaks or other sweeteners it will offer investors in its plan.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Setting aside money for college is a challenge unto itself; add in the complexities of the 529 universe, and it's no wonder so many families put off setting up a college-savings program until it's late in the game.

In some cases, the decision about whether to stick with your home state's plan or turn to another state's 529 will be an easy one. More frequently, however, the decision-making process is more nuanced, meaning that would-be 529 investors will need to balance any state-tax savings with an assessment of the quality of their plan, its total costs, and how much they plan to invest.

Here are some general guidelines about whether to stay in-state or shop around.

When to Consider Staying In-State
There are a few instances when the decision will be easy: in-state plan all the way. One such case is if your state's plan is truly best of breed or even comfortably above average. Morningstar's research now includes qualitative ratings for all of the large 529 plans, with our analysts rating each plan as either Top, Above Average, Average, Below Average, or Bottom based on the quality of its investment management, costs, and stewardship, among other factors. You can learn more about their own state's plans in our new 529 center and Premium Members can see each plan's rating in our 529 Screener.

If your state earns our "Top" rating or scores an "Above Average," you have a strong incentive to stay with the home-state plan, especially if your state offers at least some tax benefits on contributions from in-state residents. The Tax Benefits Table in Morningstar's 2010 529 College-Savings Plan Research Paper (starting at the bottom of Page 25) shows you how much a typical investor in each state's 529 plan would save in state taxes per $1,000 invested.

A second table, Estimated Basis Points of Tax Savings for Local 529 Accounts (Page 28), shows 529 state tax savings through another lens: how much 529 investors with different investment levels would benefit--in percentage terms--from the state tax break their plan offers. It underscores an additional consideration: State tax breaks deliver the biggest savings, in percentage terms, to those who aren't saving huge amounts. That's because the maximum allowable state-tax deduction maxes out at a dollar amount determined by each state, but smaller savers who can take full advantage of the deduction will get the biggest bang for their buck, in percentage terms. From these data, our analysts have provided a handy rule of thumb: For those making annual contributions of around $1,000 with moderate total college savings--roughly balances of $25,000 or less--it's usually worth staying in state versus going outside, even if a plan isn't best of breed.

Shop Around If�
On the flipside, state-tax benefits become a relatively less important consideration the more one plans to invest in a 529. For example, Indiana residents who contribute $1,000 to Indiana's CollegeChoice 529 Direct Savings Plan receive $200 worth of state tax savings and $20 in fee waivers. On a $10,000 account balance, this is equal to a single year expense reduction of 2.2%, making it a phenomenal deal for investors with smaller balances.

But if an investor who has an account balance of $100,000 in that same plan makes an additional $1,000 contribution, he or she will receive only 0.22% in state-tax benefits, because $220 in savings is a smaller percentage of the account size. Thus, the more you plan to invest, the less weight you should place on state-tax breaks when deciding whether to invest in-state or look outside. And big savers whose home-state plans earn a "Below Average" or "Bottom" rating from our analysts have added incentive to look beyond their home state's plan. Not only are their plans weak, but they're not gaining much tax-wise by staying home.

Also consider going outside of your home state's plan if your state offers no tax breaks for in-state residents. (Most plans that do not offer state tax breaks on 529 contributions don't levy state income tax.) In such instances, concentrate your search on  those plans that earn the "Top" ratings in Morningstar's qualitative rating system. However, that doesn't mean that you should dismiss your state's plan out of hand, either. For example, Alaska doesn't have a state income tax, so there are no state tax savings for Alaskans who opt for the local 529 plans. Nonetheless, Alaska's T. Rowe Price College Savings Plan earns Morningstar's "Top" rating.

If you're lucky enough to live in a state that offers "tax parity" on 529 investments, you too may want to give strong consideration to venturing beyond the local option. Tax parity simply means that the state offers tax deductions on contributions to any plan--not just the one offered by the resident's own state. Currently Arizona, Kansas, Maine, Missouri, and Pennsylvania are tax-parity states. (Investors who go out of state may forgo matching contributions or fee waivers, however.)

Finally, it's also worth considering whether the options available by staying local suit your investment preferences. For example, if you're a dedicated index investor but your plan consists solely of actively managed funds, you might consider going out of state to find an index-only plan. Ditto if you have a strong preference for a plan with "open architecture"--essentially, best-of-breed managers from several different firms rather than investment options run by a single investment company.

 

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