Sunday, November 12, 2006

Thank you, Gov. Rendell

My wife and I are expecting our first child, a daughter, next February. Being the good father, I’ve already looked at various educational savings programs (this girl is going places, baby!). Perhaps one of the most popular options is the 529 savings plan. It has the following advantages:

  • The plan can be withdrawn to pay for many education related expenses at most institutions. The child is not locked into a certain school or even schools in a certain state.
  • The benefactor of the plan can be switched to an immediate family member.
  • The gains are exempt from federal taxes.
  • The amount of contribution is practically unlimited.
  • Some states offer tax deductions on contributions from state taxes.

This last point is an important one. Although most states have a 529 savings plan, they are not created equal. Some has limited fund options while charging high management fees in addition to mutual fund expenses. While I reside in Pennsylvania, the two state plans that I like the most are from Nebraska and West Virginia.

The Nebraska plan features a wide variety of funds from Vanguard, American Century, Fidelity, State Street, Goldman Sachs, and PIMCO. The program charges a management fee of 0.60%. With Vanguard in the mix you know the underlying fund expenses will be low: only 0.09-0.37% in age based portfolios.

The Smart529 Select plan from West Virginia features funds from uber indexer Dimensional Fund Advisors that are normally accessible only through advisors. The plan changes a management fee of 0.55% with the underlying fund expenses from 0.20-0.50%.

Back to the point on state income tax deductions: More than half of states provide deductions — generally ranging from $2,000 to $12,000 — on state income-tax returns for 529 contributions. However, previously they are only available when contributing to the 529 plans administered by the state of residency. This year, however, Pennsylvania, Maine and Kansas have approved tax deductions for contributing to other state’s 529 plans. Gov. Rendell of Pennsylvania won re-election handily with 60% of the vote. I’m sure this middle-class friendly tax break didn’t hurt.

Given the flexibility of being able to switch plan beneficiaries and the ability to shop for the best plan, I’m considering starting a plan with myself as the beneficiary this year and switching to my daughter later. This way, I can take advantage of the tax break next April. In fact, this move is available to all the expecting parents out there. There is no free lunch of course, if the funds are not withdrawn for qualified education purposes, a 10% penalty is levied in addition to regular income tax on the gains. State income tax deductions may also have to be disgorged. So this is not an unlimited tax shelter. But still, even if having children is only a future possibility, if you have plans to go back to school, starting a 529 plan early is still a nice way to make tax-free gains now and jump-start college savings for your kids down the line.

In the end, this move by Pennsylvania and others will not only benefit residents for those states, but also, by increasing competition, force all 529 plans to improve as well. So there, Gov. Rendell, well done!

I did most of my research at
List of 5 best 529 plans from MSN Money.

The actual legislative change was covered by Act 67 of 2006. Amounts up to $12,000 is deductible.