Note: This video is part of Morningstar's October 2014 College Planning Report Card special report.
Adam Zoll: For Morningstar, I'm Adam Zoll. Five twenty-nine college-savings plans are widely used as a way to save for college, but how do you know if one is right for you? Here with some answers is Kathryn Spica, she is a senior fund analyst on Morningstar's 529 research team. Kathryn, thanks for being with us.
Kathryn Spica: Thanks for having me.
Zoll: So, let's talk about the pros and cons of a 529 college-savings plan first. What are some of the advantages and what are some of the disadvantages?
Spica: You get a really great tax benefit for investing in a 529 plan. For one, all of them are exempt from federal capital gains tax. So, any of the growth in your assets is exempt from that tax, which is a compelling reason to look. A lot of states also offer benefits. For many, you can get a tax credit or a tax deduction on your contributions. That will really reduce your taxes at the state level and some states also offer grants or other scholarship opportunities.
Zoll: How about the downside? Is there any negative to using a 529 to save for college?
Spica: They'll be a little bit more restrictive than a taxable account, for example. So, you have a limited set of investments for the most part. The fees can be a little bit higher. There are multiple levers of oversight. There is generally a smaller asset base to spread out the costs among. So, those are some of the options that you have to consider as you're making the choice about what vehicle is right for you.
Zoll: When you say the fees are higher, they are higher versus investing outside of the 529 wrapper in a comparable mutual fund?
Spica: Exactly. On top of the underlying fund fees, there is usually a program management fee, sometimes there is a state fee. So, there are some other layers of costs that get included in a 529 option.
Zoll: So, maybe weighing those tax benefits versus the added cost is the way to go?
Spica: Exactly. In most cases, the tax benefit will outweigh the additional costs, but it's definitely something to consider.
Zoll: And if you need the money for another purpose, a non-college-related purpose, and you take the money out, what is the penalty for that?
Spica: So, the money is always yours, which is a nice thing where you can always withdraw it, but you will be hit for a penalty. If you don't use it for a higher education expense, you have to pay taxes not just on the gains but you also get hit with a 10% penalty.
Zoll: So, once I've decided I want to use a 529 plan to save for college, how do I know if I'm getting a good deal and choosing the best plan for me?
Spica: You want to look at your home state first. You want to see what type of advantage you have by staying with your home state plan. If you have a tax deduction, it's usually a compelling reason to stay. If you don't have one, for example, or if you just want to make sure that you're getting the best value, look around nationally. There are a lot of 529 options that are really compelling. So, you want to look for states that have strong oversight and have strong managers included in their lineup.
Zoll: What about other features of a plan, such as fees and the investment lineup? Are those things I should be taking a close look at as well?
Spica: Absolutely. Fees are a really strong predictor of future performance, so you want to find a low cost option. If you are looking for passively managed funds, for example, you want to make sure that you're getting a low price because that's definitely going to eat into returns. We see a lot of variety in the cost of index-based plans. So, you want to make sure you're getting one that's on the low end.
Zoll: And one place viewers can go to research plans is Morningstar's 529 Plan Center on Morningstar.com, where we have our analyst ratings for various funds around the country.
Spica: We rate 64 plans, so we represent about 95% of the assets that are available in 529 college-savings plans. It's a good place to start. You can look at our analyst rating, which is our prediction of which plans are likely to outperform over the long haul. We also have component ratings and text that tells you a little bit more about each plan. What facets are really attractive? What investors should be considering as the costs and benefits.
Zoll: Well, Kathryn, these are very helpful hints for college savers. Thanks for sharing them with us today.
Spica: My pleasure.
Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.