Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
What are the key factors to look at when evaluating a 529 plan? Here to discuss that question is Josh Charlson. He is a senior mutual fund analyst with Morningstar.
Josh, thanks so much for being here.
Josh Charlson: Sure, nice to be here.
Benz: So Josh, you and the team have recently come out with a lot of new data and research to look at 529 plans. I wanted to discuss one thing: So you're providing a rating at the plan level, and then also the individual options within a given 529 plans are getting a rating as well. Can you discuss the different types of rating systems that you're using for each--both the plan and the individual funds?
Charlson: Sure. The ratings that we're using at the option level are similar to the traditional Morningstar star rating. So for every option in the plan, we have created a specific 529 star rating. Those are quantitative measures looking at risk-adjusted performance within the Morningstar category, and for this new data launch, we've created Morningstar categories for every 529 category. So that's a new innovation.
At the plan level, we have a more holistic qualitative Morningstar analyst rating, and those look at a bunch of different factors. They are looking at performance. They're looking at the price, which incorporates both the expense ratio and the state tax benefits. They're looking at the portfolio, the underlying quality of investments. And then two factors that go into our Stewardship ratings: parent, looking at the corporate parent, and people, which is the quality of the people managing the money, running the programs, managing the underlying investments.
Benz: Okay. So it sounds like one way to think about it is that as with the star rating, those option ratings are a quick snapshot of how a fund has balanced risk and return in the past. The plan level ratings are actually meant to be somewhat forward-looking and meant to give investors kind of a thumbs up or thumbs down?
Charlson: Yes. That's a great way of putting it. I mean we're really trying to put all of our analyst resources into evaluating the plan, looking at it from a lot of different angles, and it's really trying to say, "how well do we expect this plan to perform relative to peers in the future over the long period that you may potentially be investing in this."Read Full Transcript
Benz: So I wanted to touch also, Josh, on the tax breaks, the state tax breaks that come along with most of the plans that are available.
Can you discuss the gamut of tax breaks that are available? Some states don't offer any tax breaks at all, correct?
Charlson: Yes, it's really a wide panoply of options that are out there that you have to look at when determining the tax benefits. There is no one way that any state does it. So for every individual, you have to look at your own personal financial situation and what your state is offering.
Some states offer no in-state tax benefits, as you say. Some offer fairly generous ones. It could be a $4,000 tax deduction. Some offer up to $10,000 for joint filers. And then also the tax rate, obviously there's different tax rates, some are at 9%, some are at 3%.
So you will have to look at of these different factors. Five states offer what's called tax parity, where they actually offer their in-state residents the same tax benefits if they go out of state, so those states–their residents can look at other plans just as well as their in-state plans.
Benz: Okay. So everyone who invests in a 529 plan gets tax-free withdrawals assuming you use the withdrawals for qualified college expenses, but the state tax rates are a big swing factor, and you really need to look closely at them.
Charlson: Right. Obviously everyone benefits from the federal tax advantage. So you want to look at what does your state offer and sort of balance those benefits versus the quality of the plan and whether you should use your own state's plans or look at some of the nationally marketed plans.
Benz: So, another thing I want to tackle with you Josh, you and the team have really provided a lot more granularity on 529 plan fees than was available in the past, which is really useful, because there can be extra levels of fees that aren't in traditional mutual funds. So let's talk about the ranges that you see for expenses, and if I'm working at a 529 plan, how do I tell if it's reasonable?
Charlson: This is another sort of complicated and not very transparent area of 529 plans. One thing to keep in mind is generally they are going to be more expensive than comparable mutual funds because of the different layers involved. You have a state program manager, you have an asset manager, you just have various layers going on that don't exist with the typical mutual fund.
That said, usually we found that if there is a good in-state tax benefit that can overcome higher expenses. When you're looking at it, you have to think about a couple of things: Am I using a direct-sold plan, or am I using a broker-sold plan; the broker-sold plans are going to be more expensive. We would generally recommend if you can work on your own to select the plan, you'll benefit by going with the direct plan.
And then secondarily, is it a heavily index-weighted option within the plan, or is it more actively managed? The index ones tend to be less expensive for obvious reasons. The actively managed ones more expensive.
In direct-sold plans, the average expense ratios, in general, I'm going to take as an example an aged-based plan. Our categories are based on ages in equity levels, so take a zero-to-six age band medium equity level, that's sort of a typical plan you might start with. The average expense ratio there is about 80 basis points annually. But for indexed funds, the best ones are down near 25 basis points annually.
Benz: And they should be, right?
Charlson: Yes. So, some are higher because they add in these different administrative fees, program management fees. So even if the basic asset management fees are low, they may tack on additional fees.
When you get into the advisor-sold plans, it can be anywhere from 50 to 80 basis points higher annually. Even on front-load funds sometimes are as high as 200 basis points a year, those expense ratios. So, you really want to be careful and look for ones that are offering you a good deal.
Benz: Yeah, and if you're getting advice, you want to make sure that you need it and that its good advice.
Charlson: Yes--you may be getting good advice, and there are good advisor-sold plans, but you want to make sure it's the right plan for you.
Benz: Okay, Josh thanks for the helpful hints on picking a 529 plan. I look forward to seeing the data.
Charlson: Sure. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com