529 Plans’ Performance: Not Head of the Class

California State Treasurer Phil Angelides decried the rapid rise in higher education costs recently as he touted the state’s college savings plan to about 200 students, teachers and onlookers at Trinity Elementary School in Los Angeles.

What he didn’t mention was that those who had been investing in the Golden State Scholarshare fund over the last five years hadn’t come close to earning enough on their accounts to keep pace with rising college costs. Even when compared with the lackluster returns from the overall market, the state’s plan has performed relatively poorly, Angelides later acknowledged.

“The program has trailed the benchmarks, but we have made a number of changes and the performance has improved,” the treasurer said in an interview. “People have to look at this as a long-term endeavor.”

Of Scholarshare’s 12 funds that have five years of investment history, the best performer is a guaranteed option -- much like a savings account -- which has paid 4.29% a year on average. The remaining funds have posted average annual returns ranging from a high of 1.8% to a low of negative 3.68%.

Over the same five-year period, the S&P; 500 was down 2.71%.

Such dodgy performance may not be unusual in the relatively new realm of state-sponsored college savings plans -- dubbed “529s” for the section of the U.S. Tax Code that defines them. But comparisons are difficult because most of the plans have existed only since 2002, when tax laws changed to make them more attractive to high-income families looking for a tax-deferred way to save.

Joseph Hurley, founder of SavingForCollege.com -- a website devoted to rating and analyzing college savings plans -- recently surveyed the performance of 50 of the 85 different plans and found that they vary markedly in investment style and strategy -- and results.

Among the all-stock investment options offered by the plans, Hurley said, performance varied by huge margins, with the best-performing plans earning more than 11% a year on average over the last three years and the worst registering gains of just 4.4%. Over the same time period, the Standard & Poor’s 500 stock index returned 12.02% a year, according to Ibbotson & Associates, a market research firm based in Chicago.

For investment options evenly balanced between stocks and bonds, annual performance ranged from 9.43% to 3.45%, said Hurley, who offers individual fund performance ratings only to subscribers of his service. A balanced index, meanwhile, earned 10.72%, according to Ibbotson.

Such mediocre returns left experts with mixed views of the plans.

“A 529 plan is a mutual fund in another dress,” said Brian Greenberg, a New Jersey accountant who specializes in college saving strategies. “They are a good partial solution, but not a total solution.”

The programs offer significant advantages for well-heeled parents, experts note, because the higher the tax bracket, the larger the deduction. But those tax breaks may be small unless parents invest large sums for college -- the write-off is based only on the earnings from the 529, not the amount invested. Meanwhile there are significant tax penalties for using 529 assets for anything but higher education.

Some of the plans offer convenience and good investment options, but they’re almost always more costly than simply investing in a mutual fund, said Hurley. His research indicates that the average plan charges higher management fees than a similar mutual fund. That difference adds up over time and is worth paying only if you’re getting enough in the way of tax breaks to compensate for the additional costs.

“The best program for one person is not the best for another,” Hurley said.

What are the pros and cons?

Tax breaks

Pro: Investment returns accumulated in a 529 plan are tax-free as long as the money is used for qualified higher education expenses -- that’s generally tuition and fees, plus room and board for full-time students.

Some states -- though not California -- offer write-offs on state tax returns for contributions to the plans, as well as tax-free treatment for the money coming out.

Con: If the money is not used for college, the investment returns are taxed at ordinary federal income tax rates as high as 35% -- not preferential capital gains rates that max out at 15%. In addition, there’s a 10% federal income tax penalty. States generally impose taxes and penalties on withdrawals that are not used for college costs, too.

Then, too, middle-income taxpayers could be giving up tax credits when they pay for college with 529 assets, said Greenberg. The federal government offers the Hope Scholarship and Lifetime Learning tax credits for paying for college. But those who finance college with tax-free savings can’t use the credits, because the government considers it double dipping. In some cases, the lost credits would be worth more than the tax-free income.

Investment options

Pro: The plans are professionally managed and, usually, widely diversified. Some have low-maintenance options called “age-based portfolios” that adjust their investment strategy based on how soon the beneficiary will need the money. That provides some simplicity and investment stability for parents who don’t want to take big risks or closely manage college savings portfolios.

Virtually every state offers a 529 plan, and many states offer multiple plans. That provides lots of options. Investors generally can choose a 529 plan from any state, but experts generally advise parents to look at the plan offered by their state of residence first -- especially if the state offers tax deductions to in-state residents buying into the plan.

Con: There are so many plans to choose from that even experts say that making a choice can be difficult. Meanwhile, only a few 529 plans allow investors to fine-tune their investment mix . And there are restrictions on how often the assets can be moved, so they’re a bad choice for active investors.

Fees

Con: The plans are more expensive than similar mutual funds -- sometimes dramatically so. Experts maintain that investors must look carefully at the fees because they can drain the plans of their investment returns, and even cause losses in otherwise profitable years.

Pro: In some cases, the fees are higher because the plans offer plenty of services and allow small regular investments of as little as $25 a month. Super low-cost funds simply can’t afford high-maintenance, low-balance accounts.

Aid and other considerations

Pro: The accounts are considered the asset of the donor -- not the beneficiary -- and that’s better for financial aid purposes. Specifically, where having $10,000 in a child’s name would reduce that child’s eligibility for aid by roughly $3,500 a year, having that much in the parent’s name would reduce aid by only about $500.

Then, too, the donor who is usually a parent, can take the money back -- or give it to another child -- if the intended recipient doesn’t want to go to college, or the donor simply changes his or her mind.

Con: If the intended beneficiary turns out to be a brilliant entrepreneur and doesn’t want or need to go to college -- but could use the college savings to launch his business -- accommodating that request could cost plenty in tax penalties. (If the student wins a full scholarship and the parents don’t need the 529 funds for college, they can spend it on something else without paying the penalties, but they do have to pay the income tax.)

Parents have to be careful not to save too much in the plans. If savings overshoot expenses, the parent either needs to give the remaining savings to another aspiring student -- or face the tax penalties involved with a non-qualified withdrawal.

Kathy M. Kristof welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com