On this episode of Financially Well, the finance podcast for Millennials, I want to discuss the best 529 plans for DC residents. A 529 plan, according to the college finance website Saving for College, is “an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary.”
In other words, your investment grows on a tax-deferred basis. If you spend the money on qualifying costs, you don’t pay taxes on the distributions. They’re similar in this respect to a Health Savings Account, or HSA. And as I recently described in a video on Illumint’s Instagram page, a 529 plan account will have minimal impact on your child’s financial aid eligibility.
This type of education-specific, tax-advantaged account first started in 1986, when the state of Michigan created a prepaid tuition plan. Eventually, the IRS added Section 529 to the Internal Revenue Code, which authorized tax-free status for qualified tuition plans. Since then, more than 100 529 plans have emerged, including both college savings plans and prepaid tuition plans.
Prepaid tuition plans offer families the opportunity to pre-pay college tuition at a public institution years in advance. But they’re not as popular or highly-regarded as 529 college savings plans, which is where I’ll direct my focus today.
Since 2002, the DC government has offered the DC College Savings Plan to parents who want to save and invest for their child’s college education. Which details should you know about the DC 529 plan before evaluating whether its among the best 529 plans for DC residents? Let’s review the most pertinent facts about the DC College Savings Plan:
The College Enrollment Portfolios automatically make your investments less aggressive as your child nears college age. The Individual Portfolios invest in a single underlying fund, such as the U.S. Total Stock Market Index, that you select. And the Principal Protected Portfolio just pays a small amount of interest on your contributions.
Who manages the DC 529 plan? This isn’t an exciting detail, but you should know who has responsibility for selecting your investment options and setting the fees you pay. The DC government lists Ascensus Investment Advisors as the “investment manager.” According to the company’s website, their work involves creating “investment policies and guidelines, investment-related reporting, and periodic investment reviews.” I can’t personally speak to Ascensus’s expertise or investment performance. But I will soon talk through how the fees that they charge ultimately play a critical role in your 529 plan account decisions.
You’ve probably never heard of Ascensus Investment Advisors. I hadn’t either until I researched the details about the DC College Savings Plan. And this reality offers a small example of why parents feel anxiety about saving and investing for college. You may recognize large financial institution names such as Vanguard, and even have one or more investment accounts with them. But who is this other company that the DC government wants us to entrust with our money?
The sheer number of 529 plans that exist creates even more uncertainty and stress. You might be thinking, “Wait, there are 100 different 529 plans?” Yep, every state other than Wyoming – who offers Colorado’s plan to its residents – has created one. And even more confusingly, you’re eligible to participate in any one of them. It’s no wonder that the Millennials parents with whom I work often have resisted making any decisions about how to invest for college.
One interesting dynamic about the 529 plan marketplace is how widely the plans differ. The benefits they offer to families who participate are far from the same. So pause before you open a 529 plan account on the recommendation of a friend or colleague. Let’s say you’re a Millennial parent living in Washington, DC. That doesn’t necessarily mean that the DC College Savings Plan is among the best 529 plans for DC residents like you. 529 plans are not all created equal.
For most families, the decision comes down to two variables: tax benefits and investment fees.
There is no federal tax deduction for 529 plan contributions. However, 30 states offer a state income tax deduction or credit for 529 plan contributions. How do those state tax benefits vary?
To start, seven states offer families a tax break for investing in any state’s 529 plan. (Unfortunately, this does not include DC, Maryland, or Virginia.) More commonly, you only qualify for a tax benefit if you invest in your own state’s 529 plan. Ok, but how much of a tax break do you actually get? Illinois and Mississippi offer a tax deduction of up to $20,000 for residents who file jointly. Meanwhile, Colorado, New Mexico, South Carolina, and West Virginia allow residents to deduct the full amount of whatever they contribute. And then we have the 21 states that don’t have an income tax or, like California and Kentucky, don’t even offer residents a tax benefit.
Now let’s review how investment fees differ. Each year, the financial publication Morningstar names the “Top 529 Education Savings Plans” in the country for that year. They divide their list into a few different award categories, based in part on whether the plans charge “minimal fees.” Utah’s my529 plan received a “gold” rating in 2021, and the Morningstar researchers wrote that Utah “is the only 529 plan that’s consistently received a Gold rating since we debuted our ratings in 2012.” Utah’s plan offers a variety of strong investment options, including funds from Vanguard and Dimensional Fund Advisors. For example, the Vanguard Institutional Total Stock Market Index Fund has a low expense ratio of 0.010% (which I’ll put into context momentarily).
In 2021, the DC College Savings Plan received a “neutral” rating from Morningstar (among gold, silver, bronze, neutral, and negative categories). The accompanying Morningstar article did not describe the specific reasons for the DC 529 plan rating. But we can look at the plan’s underlying fees as one potential reason for the mediocre rating. Among the DC College Savings Plan’s relatively limited individual portfolios, the U.S. Total Stock Market Index Portfolio is the most similar to the Vanguard fund in Utah’s my529 plan. By comparison, the expense ratio in the DC College Savings Plan is 0.33%. So if (hypothetically) you invest $5,000 every year until your child goes to college, you’ll pay about $4,000 more in fees for this DC 529 plan investment than you would in Utah’s my529 plan.
In the overly complicated world of 529 plans, is opening an account as simple as comparing the tax benefits you receive against the investment fees you’ll pay? In many ways, yes. But you also don’t need to make this a time-consuming, stressful task, either. The annual Morningstar list is a reliable shortcut for eliminating most of the state 529 plans that won’t serve your family well.
You also don’t need to make a “perfect” decision, especially with a first and/or young child. Your child – or any other beneficiary – is allowed to have more than one 529 plan account. As a result, you might find yourself in a situation in the future in which you open a new account in a different state to access a tax break that previously wasn’t available to you.
Federal tax law also allows you to rollover the dollars in your account from your current 529 plan to a different state’s 529 plan. If your state’s 529 plan becomes more costly or offers worse investment options, you can take your money elsewhere. Just pay attention to any “recapture” provisions within your state’s 529 plan rules. Some states, in other words, try to take back your tax break if you roll over your investment too soon after making the contribution. In Washington, DC, for example, the DC College Savings Plan includes a provision that says:
“If a participant makes a non-qualified withdrawal or a transfer/rollover to another state’s program within two (2) years of opening the account, the amount of the deduction is “recaptured” and must be included in the participant’s District of Columbia income.”
As with most investing, the key to long-term success with your 529 plan account(s) probably lies in simplicity. For most people, you should consider your home state’s 529 plan your starting point. Is the tax benefit that your state offers valuable to you? Then you likely can proceed with that option. If you do, also pay attention to the costs associated with your investment options, and try to achieve as much investment diversification as possible within the context of those fees. If your state’s tax break is inconsequential or non-existent, then you’re free to pick a 529 plan based on the investment quality.
We’ve already covered that the DC College Savings Plan fails to provide families with sufficiently low cost investments. Should everyone bail then for another state 529 plan, such as the Utah my529 plan? Not necessarily, since local residents can deduct 529 plan contributions in DC. Specifically, the DC College Savings Plan enables DC taxpayers to “deduct up to $8,000 for married couples filing jointly, who have separate accounts. Individuals may deduct up to $4,000.” And as with many other 529 plans, your investment distributions are exempt from federal and District tax when used for qualified education-related expenses. This isn’t as strong of a tax benefit as some other states offer, but it still will help many Millennial parents manage their tax burden.
The DC College Savings Plan isn’t the best 529 plan in the U.S. But it’s still among the best 529 plans for DC residents. If you live in the District, I encourage you to put your savings goal in perspective. More than anything, the money you have available in 18 years to pay for your child’s education will depend on how soon and consistently you invest.
You can open and invest in a 529 plan yourself, so you can get started as soon as you’re ready. In fact, you can begin funding a 529 plan before your child is even born; you simply name yourself as the beneficiary to start. And if you’re still feeling nervous or anxious about the “right” 529 plan for your family, remember that you also can save and invest through other types of accounts, such as a basic, non-retirement, non-education brokerage account.
What 529 plan questions do you have at this point? I encourage you to send me an e-mail at email@example.com to ask about the other information that you would like to know. And, of course, subscribe to this finance podcast for Millennials to learn more about other ways that you can invest in your family’s future.
[Editor’s note: this article reflects the transcript (which I’ve edited for clarity) of a recent Financially Well podcast episode.]
Kevin Mahoney, CFP® is the founder & CEO of Illumint, an independent firm in Washington, DC that offers financial planning for Millennial parents. He specializes in navigating the new financial decisions that arise during our 30s and early 40s, such as repaying student loans, buying a house, saving for college, & investing for the future. In addition, Kevin also leads a financial wellness benefits program for Millennial employees around the country, including group speaking engagements.
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