Fees Fall on 529 Plans; Performance Improves

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The Wall Street Journal
By: Kristen Gerencher
November 30, 2010

If you have been putting off considering a 529 college-savings plan for your child or grandchild, you might want to think again.

Fees are coming down, and while the typical 529 plan lost almost 24% of its value in the 2008 market slide (compared with a 37% decline for the S&P 500 Index), many have eked out more gains than their mutual-fund counterparts in the past five years, according to investment researcher Morningstar Inc.

A 529 college-savings plan allows you to invest money for a family member that you later withdraw income-tax free to pay for the relative's education costs at almost any accredited college, community college or vocational school. It is funded with after-tax money but grows tax-free to cover qualified items including tuition, room and board and textbooks.

You can change the beneficiary at any time--even using the funds to pursue your own education--and you're not limited to the plans available in your home state. Also, the plans have an advantage over traditional college-savings vehicles: In the federal financial-aid calculation, investments held in a grandparent's or parent's name are generally treated more favorably--that is, they tend to reduce financial aid less than student-owned funds.

The pitfalls of having a 529 plan include fees, market risk, limited investment options and the ability to change allocation just once a year, said Joseph Hurley, founder of SavingforCollege.com, a website with 529-plan information, based in Pittsford, N.Y. And if you end up needing to withdraw the money for purposes other than education, you'll face a tax hit and a 10% penalty on the earnings, he said. In that case, "you might have been better off from the start in a taxable investment account rather than a 529."

Assets in 529 plans have ballooned to $119 billion this year, according to a recent report by Morningstar. That's up from $200 million in 1998, the year after they were created. All but three states offer at least one plan, with 82 plans available nationwide.

"Even though 529 plans tend to be more expensive than mutual funds, they have outperformed [mutual funds] over the past five years," said Laura Lutton, editorial director in the mutual-fund research group at Morningstar in Chicago.

Overall, 529 plans slightly outperformed open-end mutual funds in five of seven investment categories Morningstar measured. In the large-growth arena, 529 plans returned an average 1.01% in the five years ended Sept. 30 compared with an average 0.68% return for open-end mutual funds.

In the moderate allocation category--defined as funds with between 50% and 70% in equities and the rest in bonds and cash--529s had an average five-year return of 2.54% versus 2.29% for mutual funds.

Where 529 plans lag behind their mutual-fund counterparts, higher fees are often the reason, particularly with fixed-income funds, the Morningstar report said, adding that those lower returns may be offset by state tax breaks on some 529 contributions.

Some 529 plans that, like target-date retirement funds, shift their investment strategy over time based on the beneficiary's age, saw relatively strong returns, Morningstar found. For instance, the age-based Smart529 West Virginia Direct College Savings Plan, for that state's residents, and the Franklin Templeton 529 Plan based in New Jersey both saw 5.84% annualized returns over the five years through Sept. 30.

Write to Kristen Gerencher at kgerencher@dowjones.com

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