Op-Ed

Saving For College? It Will Cost You

Henry J. Aaron and Melissa A. Cox

The congressional tax package enacted in 2001 greatly enlarged the amount that people can deposit in tax sheltered accounts to cover higher education expenses. At the same time, however, it expanded opportunities for financial advisers to collect big fees from gullible savers.

These “529 plans”—named after the section of the Internal Revenue Code that empowers states to establish such accounts—excuse from federal income tax all investment income earned through these accounts if the funds are used to pay for educational expenses for children, grandchildren or certain others. In addition, in all but one state, funds withdrawn from these accounts are exempt from state income taxes and most states grant a small front-end deduction from state taxable income for funds deposited in such accounts.

The idea is to use these tax breaks to promote savings for higher education, not to swell the profits of the financial services industry. Yet many jurisdictions—including those in the national capital area—have established plans that impose needlessly high administrative charges that eat up most or all of the tax advantages.

Here is how 529 accounts work. People may set up accounts in their own states or in most others. States typically hire one or more financial companies to administer these programs. Some states have driven tough bargains with companies that operate frugally and efficiently, while others have contracted with companies that charge large fees. The differences among the plans now operating in every state are huge.

To see how huge, assume that two doting grandparents decide to help pay for the college education of their child’s precious newborn. They decide that they can afford to set aside $ 3,000 a year and stick to this amount for 18 years. They invest their deposits and all subsequent investment earnings in a 529 plan. If the investments yielded a steady 5 percent a year and if there were no administrative expenses, this hypothetical account would grow to $ 86,507 by the time their grandchild reached age 18. Of this sum, $ 54,000 would represent the grandparents’ annual deposits. The remaining $ 32,507 would be the investment income earned over the life of their account.

If the grandparents had set up this account in Utah, they would retain $ 83,073 to pay toward the costs of college, losing only $ 3,434 to administrative costs, or just under 11 percent of the projected $ 32,507 in investment income. Utah contracts with the Vanguard Group to manage the accounts and invest the balances. Vanguard has long specialized in funds that follow simple investment strategies that generate little trading and few administrative expenses. It charges owners of Utah-sponsored 529 accounts an annual account fee of up to $ 25 plus 0.3 percent of funds on deposit.

TIAA-CREF, also known for low administrative costs, runs the nation’s second-cheapest plan, for New York. This plan charges no flat annual fee but collects 0.6 percent of funds on deposit for managing the accounts and investing the balances. Administrative costs for an intermediate risk portfolio in New York would absorb $ 5,404, 17 percent of potential investment income.

Unfortunately, administrative costs and investment risks are higher in all other states. Residents of Wyoming, for example, would pay an average of $ 18,951 to funds managers and the state treasury, a whopping 58 percent of potential investment income. To the south, residents of Arizona could pay even more if they chose a broker-managed account and one of the investment options with double-digit annual administrative costs.

All three jurisdictions in the Washington area offer 529 plans. The District’s plan is the newest and most expensive. The exact costs depend on whether one uses a broker to set up the account, the size of one’s account, and the investment options chosen. Administrative charges would vary from $ 12,234 to $ 20,388 over an 18-year period. The lower price applies to a moderate-risk portfolio chosen by the investor. The higher price applies to a broker-directed account, invested in a higher-risk, stock portfolio. These administrative costs would eat up between 38 percent and 63 percent of potential investment earnings — depending on the broker and the style of investing chosen.

Maryland residents who invest in an intermediate risk portfolio will pay slightly more for administration than a District resident would pay on the District’s lowest-cost plan, but much less than on the District’s highest cost plan. Virginia’s 529 plan is less costly than either Maryland’s or the District’s, whether or not a broker enters the picture, but it still is more than twice as expensive as Utah’s. There’s no justification for such huge gaps between the costs of the various plans.

People saving for their kids’ education don’t have to use their own state’s plan, but state sponsorship bestows legitimacy (and publicity). And in almost all cases, people seeking 529 tax benefits must put their money in funds run by financial service firms.

Cutting through the legalese of the literature provided in many states is daunting at best, impossible at worst. And we have learned from personal experience that fund personnel in some states give conflicting and highly variable information, depending on the day one calls and who answers the phone. Nor are the fees, which come in various guises, easy to understand. Broker-managed accounts often take off the top 4 percent or more of each deposit, and many impose additional annual charges based on all funds on deposit. The fund managers charge additional annual management fees and may charge distribution fees. Some states have separate charges of their own.

For example, a District resident who asks a financial adviser to set up a 529 account invested through the Calvert Group, which is endorsed by the District, must pay a front-end charge of 4.75 percent of deposits, and then pay annual costs for administration totaling 1.38 percent of funds on deposit as well as a $ 15 annual fee. A small portion of that is funneled back to the District government. Costs are less if the depositor does not use a fund adviser, and annual charges vary depending on the account size and the particular investments chosen. Virginia’s plan authorizes a higher front-end charge for broker-managed accounts, but sets lower annual fees than does the District. In the broker-run accounts, the state, the brokers and the financial management firm all gets portions of mom and pop’s money in Virginia. Maryland’s plan does not charge a front-end fee, but imposes a $ 90 application fee (split by the state and the adviser) and an annual flat dollar charge of $ 30 per account and 1.5 percent of all funds on deposit.

What is going on here? By paying far more, do residents here get something more than the residents of Utah are getting? The answer, documented in countless studies, is a resounding “no.” Mutual funds with front-end or deferred loading charges perform no better than mutual funds that impose no such charges. Funds that impose hefty annual management fees tend to be more “actively managed” than funds that impose small fees. Active management means that fund administrators try to pick winners and losers, and tend to trade frequently. Frequent trades generate high trading costs and require more highly compensated managers. But active managers, on the average, earn returns (after subtracting trading costs and their own higher salaries) that are less than the returns earned by managers who simply buy and hold a collection of stocks or bonds that mimic the overall market. So the extra charges paid by investors in 529 accounts in states such as Wyoming, as well as in Maryland, Virginia and the District, buy investors less than nothing.

Fortunately, residents of the District, Virginia and Maryland can get most of the benefits of the 529 accounts without paying the high charges levied under the plans their governments have selected: They can set up 529 savings plans in Utah or New York. They would have to pay state income tax on the investment earnings, but they would still be likely to end up with far more than if they used a local plan. Virginia and Maryland residents can also simply prepay tuition for in-state schools.

One can only wonder why state officials established 529 plans that divert returns rightfully belonging to residents of their own states into the pockets of financial managers. Fortunately, well-informed residents need not bear most of the consequences of their governments’ dubious planning.