Mutual Funds vs. 529 Plans

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Saving for college is a tough job – on par with saving for retirement, and often in direct conflict with that goal as well. Adding to the difficulty of the task is the fact that there are so many different options out there (in terms of investment vehicles) that really muddy the waters for the individual college saver.

One question that comes up very often is whether it is just as effective to utilize tax-effficient mutual funds instead of 529 plans as we save for college. The idea is that the mutual fund can generate a higher overall return than the 529 plan due to the additional costs associated with the administration of the 529 plan.

It is a fact that most 529 plans charge management fees that have a direct impact on the overall return of the account, and it is also a fact that many tax-efficient mutual funds (such as index funds) can produce higher returns at a lower cost than most other investments. But here are a few reasons why a 529 plan is nearly always the superior choice when it comes to college savings activities:

A. Taxing Matters – with a 529 plan, you pay no tax at all (when the funds are used for Qualified Higher Education Expenses, QHEE), while with any other type of account, you’ll likely pay some tax. In my book, no tax is always better than some tax, no matter how little.

In addition, while today’s tax rates on capital gains (the tax you’d pay on an indexed mutual fund) are at the lowest they’ve historically ever been, at either 0% or 15%, depending upon your tax bracket – these rates are liable to sunset soon, increasing the rates to 10% or 20% or even ordinary income tax rates. So, the question becomes: will your student be finished with college before the rise in rates?

The third taxing matter has to do with the Kiddie Tax. Recently there have been some changes made to this portion of the tax code, with detrimental effects for parents who have counted on a strategy of repositioning funds to the child’s name in order to benefit from a lower tax rate. The child’s investment income above a minimum of $1,700 can be taxed at the parent’s highest rate all the way up to age 23!

B. Financial Aid Impact – any income that is reported on your form 1040 (which includes capital gains) is considered as a part of the calculation for financial aid for the following year. As you begin drawing monies from the mutual funds, it is possible that you will be increasing your income to the detriment of available need-based financial aid. If, on the other hand, these funds were in a 529 plan and withdrawn for use in paying QHEE, there will be no taxable income reported on your 1040, thereby having no impact on the financial aid calculation.

C. Inherent Costs – with the 529 plans, there are administrative and manager fees, but, as shown with the recent changes to the BrightStart plan in Illinois, these fees are beginning to come down. Plus, most 529 plans (Illinois’ BrightStart and Bright Directions included) have very low-cost investment options available, reducing the expense ratio of the funds themselves. Analysis of 529 plans versus mutual funds has consistently shown that, when considering the tax benefits and the costs of the two options, there are very few instances where a low-cost mutual fund performs better than a 529 plan, and then only when the 529 plan in question is one where the administrative expenses are relatively high and the taxpayer is in the lowest possible tax bracket.

In addition to the internal costs of the various options, mutual funds quite often make certain investment decisions that have tax consequences, such as distributing capital gains and dividends. 529 plans do not have to make this sort of decision, and therefore decisions can be based entirely on investment considerations.

All in all, while non-529 investments may provide additional investment options over those available in the 529 plans, unless for some reason you do not have the option of choosing a 529 plan for specific college savings, the 529 plan is the better choice across the board.