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529 plan performance is difficult to measure – it's not just about the investment returns, but also the tax benefits and fees.
Minimizing costs is usually the key to maximizing returns, but not always. Sometimes state income tax relief can offset the cost of 529 plans through higher fees. So how can you find the best 529 plan for your state and situation?
A more focused analysis of 529 plan portfolio performance, net of expenses and state income tax relief, produces results that differ from traditional 529 plan valuations.
Let's break it down.
Popular Reviews of 529 Plans
There are several well-known reviews of 529 plans, such as:
These ratings are based on a holistic assessment of the 529 plan's performance considering all investment options.
Recently, Penn-Wharton released a study comparing the performance of each state's 529 plan with a lower-cost out-of-state plan.
This study confirms two things:
- Directly sold 529 plans have lower fees than advisor-sold 529 plans, less than 1%.
- Investors in 28 states would be better off leaving the state for lower fees.
This is similar to previous research, such as the Savingforcollege.com fee study. The Penn Wharton study identified California as the lowest-cost state because it has lower average fees for its investment options.
Two investment options are enough
A key flaw in all of these studies is that they use holistic analysis to determine the best collection of investment options. Most 529 plans offer a dozen or more investment options.
But most families only need two investment options:
- Investment opportunity with high risk and high return
- Low-risk investment opportunity
They can then combine these investment options to achieve an asset allocation that provides the desired combination of risk and return. Most of an investment portfolio's performance comes from asset allocation (e.g., percentage of stocks), not the specific investments contained in the portfolio.
The risky investment option can be an S&P 500 index fund. Other stock funds, such as the Russell 2000 and a Total Stock Market Index Fund, behave similarly to the S&P 500.
Only about 75 stocks in these index funds determine the funds' performance because the funds are weighted by market capitalization. Everything else is purely a matter of taste. Chasing the latest trend, such as a REIT, a foreign equity fund or an ESG fund, typically results in poorer long-term performance.
Although costs vary depending on the portfolio, index funds generally have the lowest fees.
However, fees for the same index funds vary from 2 basis points to 65 basis points depending on the 529 plan. (A “bp” is 1/100 percent.)
Combined impact of fees and state income tax relief
The total annual asset-based fee was determined for the S&P 500 index fund for each 529 plan sold directly. Fee information was obtained from the most recent version of each 529 plan's disclosure brochure or program description.
If the 529 plan does not offer an S&P 500 portfolio, a large cap or total stock market index fund was substituted, whichever had the lowest fees. Examples include the Vanguard Total Stock Market Index Fund and the US Broad Large Cap Index Fund.
The highest state income tax break was also determined for each 529 plan. Two-thirds of states offer a state income tax deduction or tax credit based on contributions to the state's 529 plan.
The fees and state income tax breaks were combined to calculate the net return on an investment after investing $100 per month at a 6% annual return for 10 years. This more naturally reflects the typical performance of investors in 529 plans, as opposed to an analysis that assumes a flat $10,000 contribution.
On average, an annual return of 6% – about half the long-term return of an S&P 500 index fund – can be expected with an age-based asset allocation. The monthly contribution amount does not have much importance as the return on investment is proportional.
However, $100 per month is low enough to qualify for the maximum federal income tax break. The analysis assumes that the value of the federal income tax break is made as an additional contribution to the 529 plan once a year. The fees are also deducted once a year.
The result is shown in the table below, omitting Wyoming because it does not have its own 529 plan or state income tax break. The table is sorted by net ROI, from highest to lowest.
The average fees are 22.9 basis points and the average state income tax break is 5%, with a average net return of 41.9%. Ten 529 plans have a net return of 45% or more, earning a gold star.
Although California has the lowest fees overall, there are four states that charge lower fees for their S&P 500 index portfolios, and California does not offer a state income tax break. This drops California to 40th place when looking at net returns. Instead, Indiana, which has a large state income tax break, ranks first.
The dozen lowest-performing states either do not offer a state income tax break or have no state income tax. These include three states with very low fees:
- Florida
- South Dakota
- California
However, offering a federal income tax break does not guarantee good performance. Mississippi offers a state income tax deduction, but also charges the highest fees at 65 basis points, resulting in one of the worst benefits.
In contrast, New Jersey charges similar fees at 62 basis points but offers a much better state income tax break, resulting in an above-average net return on the investment.
In general there is one There is a stronger correlation between the net return on the investment and the value of the government income tax relief than with lower fees. So there is no connection between the fees and the state income tax relief Higher fees are not necessary to provide better services to families.
Best 529 Plan Performance (ROI)
Here is a breakdown of the states, their fees, tax breaks, and net return on investment (ROI) in order of ROI:
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