(NEW YORK) -- Morningstar's annual ratings of 529 college savings plans show improvements in investment choices, but fees and other downsides still make it tougher for families trying to save for a child's education. Investment ratings firm Morningstar rated 64 of the country's largest 529 college savings plans, which represent 98 percent of the more than $181 billion in U.S. 529 plan assets.
Half of the 64 rated plans are likely to outperform their peers on a risk-adjusted basis over the long term. You can view their state plan ratings here.
The plans, named after Section 529 of the Internal Revenue Code in 1996, allows anyone, such as parents and grandparents, to set up an educational savings plan for a child. The funds can be used for college or graduate school. In 2001, the federal government allowed distributions from 529 accounts to be entirely tax-exempt if used to pay for college tuition and fees, which have been increasing at an annual rate of 6 percent.
Morningstar rates the plans as gold, silver, bronze, and neutral and negative ratings. Only four plans received gold ratings, while five received silver and 23 were bronze. The plans with gold ratings were: Alaska's T. Rowe Price College Savings Plan, managed by T. Rowe Price; Maryland College Investment Plan, managed by T. Rowe Price; Nevada's The Vanguard 529 Savings Plan, managed by Upromise Investments; and Utah Educational Savings Plan.
Laura Lutton, director of 529 plan research for Morningstar, said there were very few changes at the top of the list this year, though some plans offered lower fees and better investment choices.
"There were a handful of upgrades, which is symbolic of the strong improvements we're seeing across the industry," Lutton said.
Lutton said many 529 accounts can be opened with as little as $25 as an investment, though a few plans require an initial minimum account of a few thousand dollars.
While the tax benefits are the real draw of 529 plans, as more than 30 states allow state income tax deductions on contributions but usually only for those made to their in-state plans, some states offer additional incentives for account holders and beneficiaries.
"A lot of 529 investors can withdraw proceeds and it's tax free, but many states provide benefits when you make your contribution," said Lutton, such as a tax credit or an income tax deduction at the state level. Some states offer scholarships or grants to beneficiaries who are residents. "It's good to see if there are some additional benefits beyond just saving for college."
There are some downsides to 529 plans, which show they may not be for everyone.
Adam Zoll, assistant site editor of Morningstar.com, said in general, 529 plans are good college savings vehicles, especially when you factor in the federal and state tax advantages.
But Zoll points out four possible downsides to 529 plans:
1. Investment choice limits
You must choose only from the investment choices available in the plan.
"Some plans offer pretty robust menus of funds and ETFs while others are more limited," Zoll said.
Fees can be high in some cases, and investors may end up paying more for funds used within 529 plans than they would by investing in those same funds outside 529 plans. However, Morningstar analysts have found that the tax savings usually negate those higher costs, Zoll said.
3. The Financial Aid Game
There is a financial aid impact by owning assets in a 529 plan, but this can be managed by who owns the account, Zoll said. If the account is owned by the beneficiary's parent or the beneficiary himself (assuming he is a dependent) any 529 assets reduce financial aid awards by only 5.64 percent maximum. By contrast, assets owned by the student and held outside a 529 account count 20 percent against financial aid, he said.
4. Grandparents, beware.
One caveat involves grandparent-owned 529 accounts. In that case, 529 distributions used to pay qualified college expenses may count more heavily against financial aid the following year.
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