Many 529 college savings plans, offered by various states, offer funds from sponsors such as Vanguard. The same funds may be available directly, with lower costs. Do the tax advantages of a 529 plan outweigh the lower expense ratio of a directly owned fund?
Perhaps. Under current federal law, 529 college savings plans allow money destined for higher education to grow untaxed and to be spent untaxed. On the other hand, mutual funds held outright may generate annual income tax bills (on any distributions) and a tax on any capital gains when the shares are sold.
The greater the return on the funds and the shorter the time horizon the more likely the tax deferral benefits of the 529 plan will overcome the additional expense ratio. Suppose you invest $1,000 in a 529 plan that costs 0.40 percent more than the same fund, when bought on the outside. Say your investment grows to $1,100.
If so, it will cost you an additional $4.40 in underlying fund expenses each year. That is, you’d be paying an extra 0.40 percent on your $1,100.
However, your income tax savings would be $20, assuming you sell the shares at $1,100 and pay federal capital gains tax at 20 percent. If you had the funds in the 529 plan for less than three years you would have an advantage. Over five years you would break even with keeping the assets outside of the 529 plan. Over a longer term, the lower expense ratio may outweigh the value of the tax benefits.
