Rating 529 college savings plans: use Morningstar ratings to determine the long-term performance of these programs.EXECUTIVE SUMMARY * Section 529 college savings plans offer numerous advantages and have few disadvantages compared with other options. Their benefits include tax savings, estate planning Estate Planning The overall planning of a person's wealth, including the preparation of a will and the planning of taxes after the individual's death. Notes: Contrary to popular belief, estate planning involves much more than preparing a will, and it is not only for the benefits, high contribution limits and no income limitations. One of the few drawbacks to these plans is that investment products usually are chosen by the state treasurer's office and the 529 program manager. * Withdrawals used to pay for qualified educational expenses usually are free of federal taxes. With any other withdrawals, the earnings portion is subject to federal taxes and a 10% penalty. If a child doesn't does·n't Contraction of does not. go to college, the funds generally can be used to pay for another family member. There are two types of plans: prepaid pre·pay tr.v. pre·paid, pre·pay·ing, pre·pays To pay or pay for beforehand. pre·pay  ment n. tuition For tuition fees in the United Kingdom, see .Tuition means instruction, teaching or a fee charged for educational instruction especially at a formal institution of learning or by a private tutor usually in the form of one-to-one tuition. plans and savings plans. The two most common asset-allocation options clients can choose for savings plans are age-based and static-investment allocation The apportionment or designation of an item for a specific purpose or to a particular place. In the law of trusts, the allocation of cash dividends earned by a stock that makes up the principal of a trust for a beneficiary usually means that the dividends will be treated as . * Clients will want to consider which states have the best-performing plans. Unfortunately, because 529 savings plans are relatively new, it is difficult to determine their long-term Long-term Three or more years. In the context of accounting, more than 1 year. long-term 1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. investment performance. * Because 529 plans invest in mutual funds, it is possible to use the long-term performance evaluations Performance evaluation The assessment of a manager's results, which involves, first, determining whether the money manager added value by outperforming the established benchmark (performance measurement) and, second, determining how the money manager achieved the calculated return of these funds from a rating service such as Morningstar or Lipper Business Description Lipper, Inc., a subsidiary of Reuters provides mutual and hedge fund information, analytical tools, data and commentary. Lipper's benchmarking provides a guidepost to asset managers, fund companies, financial intermediaries, traditional media, in order to calculate weighted-average ratings for a state's 529 portfolio options. ********** College expenses are increasing faster than the average paycheck, but IRC (Internet Relay Chat) Computer conferencing on the Internet. There are hundreds of IRC channels on numerous subjects that are hosted on IRC servers around the world. After joining a channel, your messages are broadcast to everyone listening to that channel. section 529 savings plans can narrow the gap. These plans provide numerous advantages and have few disadvantages compared with other options. They offer tax savings, estate planning benefits, high contribution limits and no income limitations. One of the few drawbacks is that investment decisions usually are made by the state treasurer's office and the 529 program manager. As a result clients will want to know which states have the best-performing plans. CPAs offering financial planning Financial planning Evaluating the investing and financing options available to a firm. Planning includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in the form of a financial plan, and then comparing future performance against services to their clients should be prepared to provide this information. Unfortunately, because they are relatively new, it is difficult to determine the best-performing 529 savings plans using the most popular yardstick of comparison: long-term investment performance. However, the plans invest in mutual funds whose long-term performance evaluations are available from rating services such as Morningstar and Lipper. This article shows CPAs how to use Morningstar ratings of the underlying mutual funds to evaluate a state's 529 portfolio options. These weighted-average ratings provide a long-term, risk-adjusted performance measure that can be used to compare 529 savings plans. THE BASICS OF 529 SAVINGS PLANS In qualified plans covered by section 529 of the Internal Revenue Code The Internal Revenue Code is the body of law that codifies all federal tax laws, including income, estate, gift, excise, alcohol, tobacco, and employment taxes. These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq. , withdrawals used to pay for qualified educational expenses usually are free of federal taxes. With any other withdrawals, the earnings portion is subject to federal taxes and a 10% penalty If a child doesn't go to college, the funds generally can be used to pay for another family member. (For more on investing in these plans, see "The Best Use of Spare Cash," page 41.) Section 529 authorizes two types of plan: prepaid tuition plans and savings plans. Generally, state-sponsored prepaid tuition plans offer tuition contracts that allow contributors to lock in the cost of tuition and mandatory Peremptory; obligatory; required; that which must be subscribed to or obeyed. Mandatory statutes are those that require, as opposed to permit, a particular course of action. fees at an in-state public college or university. Unlike these prepaid tuition plans, most 529 savings plans do not offer any guarantees. The 529 plan program manager, usually a large mutual fund company, collects contributions and invests them in funds or other financial instruments. The two most common asset-allocation choices for 529 savings plan investors are age-based and static-investment allocation. With an age-based allocation, the assets are moved over time to portfolios with progressively lower percentages of stock and higher percentages of fixed-income securities Fixed-income securities Investments that have specific interest rates, such as bonds. to minimize In a graphical environment, to hide an application that is currently displayed on screen. For example, in Windows and Mac, the application's window is removed from the screen and represented by an icon on the Windows Taskbar. In the Mac, the icon is placed in the Dock. See Win Minimize windows. risk as the child gets closer to college age. Conservative age-based options move out of equities quickly; aggressive ones move out more slowly. Static-investment allocation options maintain a constant equity percentage as a beneficiary beneficiary Person or entity (e.g., a charity or estate) that receives a benefit from something (e.g., a trust, life-insurance policy, or contract). A primary beneficiary receives proceeds from a trust or insurance policy before any other. grows older. Many 529 plans offer low-, medium- and high-equity content options and most allow account owners to use more than one. By investing in multiple options, clients can create customized portfolios to match their risk preference. For example, if a 529 account owner wants a portfolio with 75% of its assets in equity funds and 25% in fixed-income funds, he or she can put $750 of each $1,000 contributed into a 100% equity option and $250 into a 100% fixed-income option. CALCULATING WEIGHTED-AVERAGE MORNINGSTAR RATINGS To determine its mutual fund star ratings, Morningstar classifies funds into 69 categories, then calculates risk-adjusted returns Risk-Adjusted Return A measure of how much risk a fund or portfolio takes on to earn its returns, usually expressed as a number or a rating. Notes: This is often represented by the Sharpe Ratio. The more return per unit of risk, the better. for each fund, taking into account asset-based expenses and loads. Morningstar rates the funds (from 1 to 5 stars--5 being the best) in each category based on these risk-adjusted returns. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke" put differently , funds * In the top 10% of their category receive five stars. * In the next 22.5% receive four stars. * In the middle 35% receive three stars. * In the next 22.5% receive two stars. * In the bottom 10% receive one star. Morningstar calculates star ratings for 3-, 5- and 10-year periods and combines them to obtain a comprehensive star rating for each mutual fund. The online exhibit at www.aicpa.org/pubs/jofa/sep20 06/eighme.xls, shows weighted-average Morningstar ratings for selected 529 options for each state that have been calculated using the comprehensive star ratings of the options' underlying mutual funds. The online exhibit provides age-group performance evaluations by giving weighted-average Morningstar ratings for a sample of age-group portfolios. This sample includes portfolios for newborns and children ages 6, 12 and 18. The weighted-average Morningstar ratings of these age-group portfolios have been used to calculate the overall age-based option ratings. The online exhibit also gives weighted-average Morningstar ratings for three types of static-investment option: growth, balanced and conservative. Taking one state as an example, exhibits 1 and 2, below and on page 48, use Connecticut's age-based option to illustrate the method used to calculate the weighted-average Morningstar ratings in the online exhibit. (Practitioners can follow the example in these exhibits to make their own calculations for different states, keeping in mind that fund ratings may need to be updated since they can change over time More information can be found at www.morning star.com.) A portfolio's weighted-average Morningstar rating is based only on its rated funds. If an age-group or static portfolio does not have at least 75% of its non-money-market assets in Morningstar-rated funds, the portfolio is not given a weighted-average Morningstar rating. If an age-group portfolio is unrated, an overall rating is not calculated for the age-based option. In addition to weighted-average Morningstar ratings, the online exhibit provides the total asset-based expense for each 529 option and the portion of this expense accounted for in the option's weighted-average Morningstar rating. A 529 option's total asset-based expense is usually made up of two parts: the asset-based expense charged by the 529 program manager and the asset-based expense charged by the option's underlying mutual funds. The asset-based expense charged by the program manager is not accounted for in the option's weighted-average Morningstar rating. On the other hand, most of the asset-based expense charged by the option's underlying mutual funds is accounted for in the rating. INVESTING IN OUT-OF-STATE out-of-state adj. Of, relating to, or being from another state. 529 PLANS Of course, CPAs should remind clients that investment returns and ratings are only part of the puzzle “Puzzle solving” redirects here. For the concept in Thomas Kuhn's philosophy of science, see normal science. A puzzle is a problem or enigma that challenges ingenuity. . When deciding whether to invest in an out-of-state plan, clients should consider other issues, such as expenses and tax consequences. Out-of-state 529 account owners sometimes pay higher expenses than state residents do. For example, some 529 plans require out-of-state account owners to invest in load-based funds resulting in additional asset-based expense. If this is the case, the online exhibit assumes, for rating purposes, that class A shares are purchased. Class A usually is the most advantageous load share class for long-term investors Long-term investor A person who makes investments for a period of at least five years in order to finance his or her long-term goals. . Owners of an out-of-state 529 account might lose a state income tax deduction Tax deduction An expense that a taxpayer is allowed to deduct from taxable income. tax deduction See deduction. or tax credit for contributions to the account and, in a few states, do not receive an exemption exemption n. 1) in income taxation, a credit given for each dependent, blindness or other disability, and age over 65, which result in a downward calculation in tax levels. from state income tax for qualified withdrawals. About ha]f of the states allow their residents a state income tax deduction for some or all of a contribution to an instate in·state tr.v. in·stat·ed, in·stat·ing, in·states To establish in office; install. 529 account, but not for contributions to an out-of-state account. If an out-of-state investment seems attractive, the client might consider funding an in-state 529 account to the maximum deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). amount and putting any further contributions into an out-of-state account. A client in a state that taxes qualified withdrawals from out-of-state 529 accounts should consider rolling an out-of-state 529 account into an in-state account before withdrawals begin to avoid these taxes. (To learn more about plan details, go to www.savingforcollege. com/529_plan_details.) A VALUABLE COMPARISON TECHNIQUE For many 529 account owners, the advantages of investing in an out-of-state 529 plan outweigh out·weigh tr.v. out·weighed, out·weigh·ing, out·weighs 1. To weigh more than. 2. To be more significant than; exceed in value or importance: The benefits outweigh the risks. the possible disadvantages. An out-of-state plan may provide diversification Diversification A risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance. Notes: Diversification is possibly the greatest way to reduce the risk. benefits, be better-suited to an account owner's investment style and be more compatible with an owner's non- non- word element [L.]not . non- pref. Not: noninvasive. 529 investments. Clients who invest in an out-of-state 529 plan, regardless of the reason, share a common goal: obtaining good investment performance at a fair expense. The weighted-average Morningstar ratings and expense figures in the online exhibit located at www.aicpa.org/pubs/jofa/sep 2006/eighme.xls can help CPAs and their clients identify the 529 plans that will allow them to achieve this goal. Most 529 account owners are investing for the long term and, as part of their overall decision-making decision-making, n the process of coming to a conclusion or making a judgment. decision-making, evidence-based, n a type of informal decision-making that combines clinical expertise, patient concerns, and evidence gathered from process, would find it useful to compare the long-term performance history of various 529 plans. Because of the newness of most 529 plans, long-term performance measures are not commonly available. Until they are, using the procedure outlined in this article to determine weighted-average Morningstar ratings for a 529 plan's portfolio options is a good alternative. 529 Planning Tips * Clients should consider the proper timing of contributions. A single-year 529 contribution of up to $60,000 ($120,000 for married couples electing to split gifts) can be treated as five equal annual gifts. If the contributor makes no other gifts to the beneficiary during this five-year period, the contribution will be exempt from gift tax and the contributor's lifetime gift exemption will not be reduced. * To minimize taxes, advise clients to consider making nonqualified withdrawals from a 529 plan payable to the beneficiary if the beneficiary's marginal tax rate Marginal Tax Rate The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. Notes: Many believe this discourages business investment because you are taking away the incentive to work harder. is lower than the owner's and the plan permits such payments. * Instead of closing a 529 account, advise clients to transfer it to a new beneficiary who is a qualifying family member of the original beneficiary to avoid income tax and the 10% withdrawal penalty. * When a state's allocation options do not match a 529 account owner's risk preference, clients should consider investing in a combination of static-investment options to create a customized portfolio. * If a 529 contributor invests in a load plan, the most advantageous share class for long-term investors is usually class A. * Before opening an out-of-state 529 savings plan account, clients and their CPAs should consider the possible tax consequences. By investing out of state, a contributor might lose a state income tax deduction or a tax credit for contributions and might be subject to state income tax on qualified withdrawals from the account. * A client interested in investing in an out-of-state 529 account who does not want to give up a state income tax deduction for contributions should consider funding an in-state account to the maximum deductible amount and putting further contributions into an out-of-state account. Jan E. Eighme, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , PhD, is assistant professor, Department of Accountancy, Richard T. Farmer School of Business The Farmer School of Business at Miami University is the 12th best public undergraduate business school according to Business Week. The departments include Accountancy, Economics, Finance, Management, Marketing and Decision Science/Management Information Systems. , Miami University Miami University, main campus at Oxford, Ohio; coeducational; state supported; chartered 1809, opened 1824. The library has extensive collections in literature and American history, including the William Holmes McGuffey Library and Museum and the Edgar W. , Oxford, Ohio Oxford is a college town located in the southwestern portion of the U.S. state of Ohio in northwestern Butler County in Oxford Township, originally called the College Township. The population was 21,943 at the 2000 census (approximately 16,000 students are included in this figure). . Her e-mail address See Internet address. e-mail address - electronic mail address is eighmeje@muohio.edu See .edu. (networking) edu - ("education") The top-level domain for educational establishments in the USA (and some other countries). E.g. "mit.edu". The UK equivalent is "ac.uk". .
Exhibit 1 Connecticut's Age-Based Option
Asset Allocation
Percentage
Morningstar
Funds Used in Connecticut's Star
Age-Based Option Rating (1) Newborn Age 6
TIAA-CREF Equity Index 4 60 52
TIAA-CREF 4 7.5 6.5
International Equity
TIAA-CREF 4 6.25 8.75
Inflation-Linked Bond
TIAA-CREF 3 7.5 6.5
Real Estate Securities
TIAA-CREF Bond 3 18.75 26.25
TIAA-CREF Money Market 0 0 0
Total Assets 100 100
Percentage of total assets
in Morningstar-rated
mutual funds 100 100
Percentage of non-money-market
assets in Morningstar-rated
mutual funds 100 100
Is the percentage of non-money-
market assets in Morningstar-rated
mutual funds greater than 75%? Yes Yes
Asset Allocation
Percentage
Funds Used in Connecticut's
Age-Based Option Age 12 Age 18
TIAA-CREF Equity Index 32 16
TIAA-CREF 4 2
International Equity
TIAA-CREF 15 8.75
Inflation-Linked Bond
TIAA-CREF 4 2
Real Estate Securities
TIAA-CREF Bond 45 26.25
TIAA-CREF Money Market 0 45
Total Assets 100 100
Percentage of total assets
in Morningstar-rated
mutual funds 100 55
Percentage of non-money-market
assets in Morningstar-rated
mutual funds 100 100
Is the percentage of non-money-
market assets in Morningstar-rated
mutual funds greater than 75%? Yes Yes
(1) Star ratings as of June 12, 2006.
Note: The money market fund in this exhibit does not have
a Morningstar rating because Morningstar does not rate money
market funds or any funds less than three years old.
Exhibit 2
Calculation of Weighted-Average Morningstar
Ratings Using Connecticut's Age-Based Option
Newborn (.60 * 4 stars) + (.075 * 4 stars) + .0625 * 4 stars) +
(.075 * 3 stars) + (.1875 * 3 stars) = 3.74 stars
Age 6 (.52 * 4 stars) + (.065 * 4 stars) + (.0875 * 4 stars) +
(.065 * 3 stars) + (.2625 * 3 stars) = 3.67 stars
Age 12 (32 * 4 stars) + (.04 * 4 stars) + (.15 * 4 stars) +
(.04 * 3 stars) + (.45 * 3 stars) = 3.51 stars
Age 18 (16/55 * 4 stars) + (2/55 * 4 stars) + (8.75/55 * 4 stars) +
(2/55 * 3 stars) + (26.25/55 *3 stars) = 3.49 stars
Overall [(100 * 3.74) + (100 * 3.67) + (100 * 3.51) + (55 * 3.49)]
= 3.62 stars
[(100 + 100 + 100 + 55)]
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