Investors choosing to open a 529 college savings plan portfolio are given options with sometimes confounding names, like “choice-based” tracks or “enrollment-based tracks .” They need to choose a plan with a low “expense ratio” and pay attention to “front end loads.”
And that’s assuming they’ve gotten past the name for the plans: 529, a somewhat off-putting term named for the section of the Internal Revenue Code that authorizes them.
A study by financial services firm Edward Jones earlier this year found two-thirds of Americans still don’t know what a 529 plan is. Retirement savings plan was the most common guess.
Here’s a tip for that majority of Americans unfamiliar with 529s: A 529 is a college savings plan in which earnings are not subject to federal tax as long as they go toward qualified education expenses, and are often eligible for state tax breaks as well. Investors can choose from plans in nearly any state and portfolio options include stock mutual funds, bond mutual funds, money market funds and age-based portfolios.
Knowing these important terms can help college savers choose the appropriate 529 account.
1. Direct-sold versus advisor-sold plans: Deciding between these two plans is one of the first decisions a 529 plan investor will make. Many states offer both types of plans. Julie Ford, a fee-only financial planner and owner of Ford Financial Solutions LLC in New York, calls the direct-sold plan a “DIY, or do-it-yourself, option.” In a direct-sold plan, investors buy the plan directly from the program manager.
An advisor-sold plan is an “outsourcing option,” she says. Only investors using financial advisors can buy the plan.
[Learn the pros and cons of using a financial advisor for college savings.]
The distinction matters because there will be different investments available depending on the type of plan. Often, but not always, advisor-sold plans offer more portfolios so that brokers can customize them to their clients’ needs. Fees also tend to be slightly higher with advisor-sold plans, says Leo Acheson, an analyst with Morningstar Inc., which conducts research on 529 plans.
“At the end of the day, the broker needs to be compensated in some way for the advice they’re giving you — taking up the account and managing it for you on your behalf — so you might end up paying a little more in fees with an advisor-sold account,” Ford says.
2. Age-based versus static portfolios: The names may differ slightly depending on the state and plan manager, but most states offer two types of portfolios: age-based, sometimes called enrollment-based, and static, sometimes called fixed or choice-based.
Age-based portfolios shift assets primarily from stocks to bonds and cash as the beneficiary ages. Investors can choose a portfolio based on the age of their child and their own risk tolerance.
[Discover five options for risk-averse college savers.]
“When your kid is 15 or 18 years out from college, you can afford to have a little more risk in your portfolio,” says Ford. “As the child gets older, you want a little safer portfolio. You want a little less risk to make sure that money is secured and still there when you need it.”
A static portfolio consists of traditional stock, bond and allocation strategies that investors can use to build their own portfolios, Acheson says.
3. Expense ratios: The portfolio’s expense ratio is important because it represents the cost of a plan’s investment options, including the program management fee, investment management fee and sometimes a state fee, Acheson says. It is typically expressed as a percentage of assets invested and is readily available when investors look at investment options on the plan’s website.
Expense ratios on direct-sold plans range from 0.08 percent to 1.44 percent, according to Morningstar. An expense ratio of 0.1 percent means an investor is paying a fee of one-tenth of a percent. The difference may not sound like much, but can add up to hundreds or thousands of dollars over the course of an investment.
“The higher the expense ratio, the more expensive that fund is, and the less money that you end up putting to work at the end,” Ford says.
4. Enrollment fees and annual maintenance fees: These are dollar-based fees that are separate from the expense ratio. In some cases, these can be waived, Acheson says. Roughly half of all plans charge a maintenance fee, ranging as high as $30 a year, according to Morningstar.
5. Front-end load: This only applies to advisor-sold plans. It’s a commission charged to an investor when buying a plan, charged at the time of the initial purchase.
6. Index strategy: Some portfolios use an index strategy, a passive investment strategy that aims to mimic a given market. The idea is to try to track or stay in line with a particular index, such as the S&P 500, rather than trying to beat the market, Ford says.
[Know three important facts about stocks within a college savings plan.]
Active-management portfolios are run by managers who aim to beat market indices. Ford says an active-management option may cost more, but people who choose it believe they will earn a higher return, Ford says.
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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6 Terms to Know Before Opening a 529 College Savings Account originally appeared on usnews.com
