Tuesday, May 29, 2007
A Bum Deal
A 529 plan is a college savings account that has a number of tax advantages. Most significantly, earnings are untaxed if used for college education. In Montana, another benefit is that contributions to the state's plan are deductible from income taxes. Unfortunately, Montana's plan† suffers from fees so high as to more than offset the benefits.
A deduction against Montana income tax is worth at most 5.175%‡. The Montana plan charges a 5.5% fee* against each contribution, a larger percentage than the value of the deduction. Compare that to Vanguard's 529 plan which charges no sales fee. If you contributed $1,000 to each plan, the Vanguard plan would have a $1,000 balance, while the Montana plan would have a balance less than the original contribution, even if you also contributed your tax deduction. Sadly, the state is offering a tax break to encourage families to act against their best interest.
The Montana plan is also a bum deal in subsequent years. Mutual funds make money by charging a percentage of an account's balance each year. This percentage is called the fund's expense ratio. The funds in Montana's plan have ratios ranging from 1.18% to 1.44%*. The funds in Vanguard's plan have ratios ranging from 0.5% to 0.7%, less than half that of Montana's funds.
To flesh out this comparison, I've published a spreadsheet comparing the growth of a moderate risk fund from each plan. Despite the income tax deduction advantage Montana's plan enjoys, it has a lower balance in every year compared to the Vanguard plan. By the child's 18th birthday, Montana's plan has fallen nearly $20,000 behind. The difference is entirely due to the plan's excessively high fees. For each 1% of Montana's population that uses the Montana-529 plan, an out-of-state corporation earns nearly one million dollars in unnecessarily high fees.
Should we feel some fealty toward the plan because it is Montana's? Absolutely not. The plan is operated by a California company with no offices in Montana. The state's government has essentially licensed Montana's good name to this company in exchange for a bad deal for its citizens.
I'm not the only one who's noticed the deficiencies of Montana's 529 plan. SavingForCollege.com published a report showing that Montana's plan had the highest fees in the country, fees that were usually double, if not triple, those of other states' plans. Arizona dropped Pacific Life's plan last year in favor of plans with lower fees. Montana is now the only state using that company's funds. SmartMoney singled out Montana's plan for having high fees. Morningstar also mentions the plan's high fees and that parents of relatively young children are better off going to another plan.
Clearly something should be done. I propose three changes.
- Montana should either find a new 529 plan with lower fees or should require Pacific Life to lower its sales load and expense ratios. We should fix what's broken.
- Montana should offer an income tax deduction for contributions to any 529 plan, not just the state's own. We should not use tax breaks to entice Montanans to settle for a bad deal. We should reward Montanans for saving for college even if our plan remains uncompetitive and they're forced to look elsewhere.
- We should prevent Montana from slipping into this situation again. The legislature should order periodic reports of the competitiveness of our 529. The Board of Regents, the government body responsible for the plan, has been negligent. Which of the Regents knows that their fund has the highest fees in the county? Hopefully, periodically shining a light on this dark, dusty corner of its duties will make the Board more mindful.
Footnotes:
† There are actually two 529 plans offered by Montana. The plan I'll refer to throughout is the Pacific Life plan. The other plan is offered by College Savings Bank. That plan only offers stable-value investments, such as CDs. These investments yield less than the rate of college inflation. An investment in these options is essentially a money losing venture, as the purchasing power of the funds will be less at the time they're needed than at the time they were invested. Consequently, I consider plans like Pacific Life's, which invest in stocks and bonds, which can achieve average returns above the roughly 6% college inflation rate, the only option. Within the Pacific Life plan, three classes of shares can be purchased. I'm only considering the class A shares, as they're the best long term investment.
‡ The highest personal income tax rate in Montana is 6.9%. Any amount deducted from state taxes is taxed by the federal government. If a taxpayer qualifies for the 6.9% Montana bracket, then he will pay at least 25% in federal taxes. The net value of the state tax deduction is calculated by: (deductible amount) * (state rate) * (1-federal rate), or 6.9% * 75% = 5.175%. See this tax deduction calculator for a better explanation.
* Please see the Pacific Life 529 Prospectus pages 21 through 23.
