How to Pick a 529 Plan with Morningstar

Morningstar

Christine Benz: Hi I’m Christine Benz for Morningstar.com. What are the key
factors to look at when evaluating a 529 plan? Here to discuss that
question is Josh Charlson. He is a Senior mutual fund analyst with
Morningstar. Josh thank you so much for being here?

Josh Charlson: Sure nice to be here.

Christine: So Josh you and the team have recently come out with a lot of new data
and research to look at 529 plans. I wanted to discuss something so you’re
providing a rating at the plan level and then also the individual options
within a given 529 plans or getting a rating as well, can you discuss the
different types of rating systems that you’re using for each both the plan
and individual funds?

Josh: Sure, the ratings that we’re using at the option level are similar to the
traditional Morningstar rating so for every option in the plan we’ve
created a specific 529 Star rating as a quantitative measures looking at risk
adjusted performance within the Morningstar category and for this new
data launch we’ve created Morningstar categories for every 529 categories
so that’s a new innovation.

Christine: Okay.

Josh: At the plan level we have a more holistic qualitative Morningstar analyst
rating and those look at a bunch of different factors. They’re looking at
performance. They’re looking at the price which incorporates about the
expense ratio and the state tax benefits. They’re looking at the portfolio
the underlying quality of investments and then two factors that go into our
stewardship ratings apparent looking at the corporate parent and people
which is the quality of the people managing the money and running the
programs managing the underlying investments.

Christine: Okay so it sounds like one way to think about it is that as with the star
rating those option ratings are sort of a quick snapshot of how fund is
balance risk and can return in the past. The plan level ratings are actually
meant to be somewhat forward looking and meant to give investors kind
of a thumbs up or thumbs down.

Josh: Yeah that’s a great way of putting and we really trying to put all of our
analyst resources into evaluating the plan looking at it from a lot of
different angles and it’s really trying to say how well do we expect this
plan to perform relative to peers in the future over the long period that you
may potentially be investing in us.

Christine: Um-hmm. So I wanted to touch also Josh on the tax breaks that the state
tax breaks that come along with most of the plans that are available can
you discuss kind of the gamete of tax breaks that are available some states
don’t offer any tax breaks at all correct?

Josh: Yeah, it’s really kind of wide panoply of options that are out there that you
have to look at when determining the tax benefits. There’s no one way that
any state does it so for every individual you have to look at your own
personal financial situation and what you’re state is offering. Some state
offer no tax in state tax benefits as you say. Some offers fairly generous
ones. It could be a $4,000 tax deduction. Some offer up to $10,000 for
joint filers and then also the tax rate obviously there’s different tax rates
somewhere at 9% somewhere at 3% so you really have to look at all of
these different factors 5 states offer what’s called tax parody where they
actually offer their in state residence the same tax benefits if they go out of
states so those states. Their residents can look at other plans just as well as
their in state plans.

Christine: Okay so everyone who invest in the 529 plan gets a tax free withdrawals
assuming you use the withdrawals for qualified college expenses but the
state tax rates are a big swing factor and you really need to look closely.

Josh: Right obviously everyone benefits from the federal tax advantage so you
want to look at what is your state offer and sort of balance those benefits
versus the quality of the plan and whether you should use your own states
plan or look at some of the nationally marketed plans.

Christine: Right so another thing I want to tackle with you Josh, you and the team
have really provided a lot more granularity on 529 plan fees than was
available on the past which is really useful because there can be extra
levels of fees that aren’t in traditional mutual funds so let’s talk about kind
of the ranges that you see for expenses and if I’m looking at a 529 plan,
how do I tell if it’s reasonable?

Josh: Yeah this is in another sort of complicated not very transparent area of 529
plans. You know one thing to keep in mind is generally they are going to
be more expensive than comparable mutual funds because of the sort of
different layers involved. You have a state program manager. You have an
asset manager. You just have various layers going on that don’t exist for
the typical mutual fund. That said usually we found that if there’s a good
in state tax benefit that can overcome higher expenses.

When you’re looking at it you have to think about a couple of things am I
using a direct sold plan or am I using a broker sold plan. The broker sold
plans are going to be more expensive. We generally recommend if you can
work on your own to select the plan you’ll benefit by going with a direct
plan and then secondarily is it heavily indexed weighted option within the
plan or is it more actively managed.

The index ones tend to be less expensive for obvious reasons actively
manage ones more expensive. In direct sold plans you know the average
expense ratios on in general I’ m going to take as an example an age based
plan our categories are based on ages and equity level so take a zero to a 6
age band medium equity level that sort of a typical plan you might start
with. The average expense ratio there is about 80 basis points annually but
for index funds the best ones are down near 25 basis points annually.

Christine: It should be right.

Josh: Yeah so some are higher because they add in these different administrative
fees program management fees so even if the basic you know asset
management fees are low they may tack on additional fees. When you get
into the advisor’s old plans that can be anywhere from 50 to 80 basis
points higher annually even on front load of funds sometimes they’re as
high as 200 basis points a year those expense ratios so you really wanted
to be careful and not for ones that are offering you a good deal.

Christine: Yeah and if you’re getting advise you want to make sure that you need it
and that it’s good advice.

Josh: Yeah you may be getting good advice and there are good advisers sold
plans. You want to make sure it’s the right plan for you.

Christine: Okay Josh thanks for the helpful hints on picking a 529 plan.

Josh: Sure thanks for having me.

Christine: Thanks for watching I’m Christine Benz for Moringstar.com.