If I had an FAQs page, one of the top questions would be, “Why pay the higher expense ratios in 529 plans when there are so many low-cost, tax-efficient investments available?” It’s certainly true that you could construct your own portfolio and then have the added bonus of not worrying about whether your child will attend college or not. However, “tax-efficient” is not the same as “tax-free” and I would suggest that for most families, the benefits of tax-free are greater than the benefits of low expense ratios. Even more so when you add in the other benefits of 529 plans.
For comparison purposes, I’ll use the Oregon College Savings Plan. It’s got fairly average expense ratios and has Vanguard funds as its underlying investment but since it only has one investment option per age band, the comparison is more straightforward.
Let’s say your baby is born in 2020 and you’re going to put $4,000 into college savings, right now. You’ve got 18 years to accumulate, so you want to be pretty aggressive. You want low-cost, broadly diversified, passive investments, and you’ll use ETFs to be as tax-efficient as possible in your taxable account. So you choose to split your investment between Vanguard Total Stock Market ETF (VTI) and Vanguard Total International Stock ETF (VXUS). That’s actually a pretty close match to the Oregon College Savings Plan 2038 Enrollment Year portfolio, but without the 0.25% state administrative fee layered on top of the funds’ expense ratios.
VTI’s expense ratio is 0.03%; VXUS’s is 0.09%. The 529 uses “Institutional Plus” share classes so their expense ratios are lower—0.02% for the Total Stock Market fund and 0.07% for Total International—but they add a 0.25% administrative fee to the portfolio. That 0.25% will cost you $10 in performance the first year with a $4,000 investment. So you’re definitely ahead on expense ratios here.
But let’s look at the difference between “tax-efficient” and “tax-free.” As a tax-free account, the 529 works like your Roth IRA: you don’t pay taxes on any growth or income that the account generates on an ongoing basis. Tax-efficient VTI has averaged a 1.84% dividend yield the last few years; VXUS has averaged 2.99%. That means that your $2,000 in VTI will generate $36.80 in taxable dividends in a typical year, and $2,000 in VXUS will generate $59.80. If you’re in the 22% tax bracket, those dividends will cost you $21.25 in federal taxes the first year. We Oregonians would pay another 9% to Oregon for a total tax cost of $30.21 annually.
Most of us don’t think of taxes that way, especially since those aren’t paid out of the investment the way expense ratios are. But in this case, the lower expense ratio is at least three times as costly because of the tax impact.
That’s the annual piece; fast forward 18 years and it’s time to spend the money. Suppose you contributed $1,000 per year and your account grew 5% each year until college. It’s now worth about $37,000, so you’ll withdraw $9,250 each year for college. 43% of the account balance is attributable to growth. If it’s in a taxable account, that means you’ve got about $4,000 of taxable income each year. Fortunately it’s long term capital gains so the federal tax rate is 15%, which will cost $600 in federal taxes; we Oregonians will pay another $360 in state taxes. That means that your $9,250 gross distribution is really only $8,290 net of taxes. But that’s not all: the $4,000 in gain is also reported as income on your FAFSA, raising your EFC by $1,880.
What about the 529? Let’s suppose you earned a 4.75% rate of return to account for the higher expense ratio. That would result in an account balance of $35,700 at the start of college, so your annual withdrawal is only $8,925. But you actually get the full $8,925. And where does a 529 distribution go on your FAFSA? Remember the secret benefit of 529 plans: The distributions are not reported on the FAFSA. So all that tax-free growth over the years has the added bonus of not increasing income for your EFC in the FAFSA, or bumping your income up over the threshold for the AOTC, or having any other impact on you financially.
All this is before we even factor in a state tax benefit, if you live in one of the states that offers one. In the Oregon plan, $1,000 in annual contributions would get a typical family $100 of tax credit annually. What if they reinvested that $100 into the plan each year? Then they’d have $38,385 in the 529 when college started.
And that’s why tax-free growth is better than tax-efficient growth.