Every state runs its own Section 529 savings plan, and unfortunately not all college plans are created equal.
Is your child eventually going to wish he’d been born in another state? The federal government did a great service 17 years ago when it allowed states to set up Section 529 college savings plans as a way for overwhelmed parents to save for the ever-rising costs of higher education. The money you put in today gets to grow free from any federal taxes until you decide to spend it — a big advantage that can massively multiply your savings, especially if you start putting money away years before your child goes to college.
But each state runs its own plan, and unfortunately not all college plans are created equal. And if you want to take advantage of any potential state tax benefits, you have to invest in the plan offered by your home state. The result: The plans are an essential monopoly in most states, granted by the state treasurer or other officials to a money management firm. And some state plans are taking advantage by charging oversize fees.
My husband and I got a firsthand glimpse of the problem a few years ago when setting up college savings plans for our children, a daunting process even for someone who spends her days following financial markets. Most plans offer a large number of funds, from actively managed ones to passive ones that track stocks or bonds. The sheer number of options confounded me, so I called the best person I could think of to ask for advice: Warren Buffett. He told me what he often tells investors: If you’re not a money manager, you’re better off investing in a fund that indexes the stock market. If stocks go up over time, your investment rises, and you’ll pay far lower fees than you would for an actively managed fund. (Buffett says the most likely scenario is that $10,000 in a stock index fund will grow to $40,000 in 20 years.)
With that in mind, I began researching administrative fees. To invest in a plain-vanilla stock index fund in my home state of New Jersey’s college savings plan, I would have to pay 40 basis points. A similar index fund in Nebraska’s college savings plan would cost 51 basis points, and 42 points in Nevada. And if you buy through an adviser in many states, you can pay 85 basis points for those same funds. But invest in a stock index fund in California and you can pay as little as 18 basis points, or in Arizona just 19 basis points.
It may not sound like a big difference — indeed, these are all fees of less than 1%. But over 10 years for a $10,000 account, a 75-point spread in administrative costs can easily add up to over $1,000 or more in extra fees you pay, and that’s not chump change.
So what gives? “It’s a complicated business,” explains Laura Lutton, the head of 529 research at Morningstar, which rates about 60 college savings plans a year. “You’re mixing money management and state politics, so all kinds of things can happen.”
Part of the issue has to do with economies of scale. New York’s plan is able to charge just 17 basis points for its stock index fund because it has a whopping $13.2 billion in assets under management. Alabama, meanwhile, which has just $164 million in assets, charges 30 basis points to invest in an index-based stock fund. Obviously state officials with a bigger purse can drive a better bargain when it comes to fees.
The good news: The purse seems to be growing in every state. The industry now has about $187 billion in assets, up from $166 billion at the end of last year. And that extra heft has given the states more leverage with money managers. “If you’d looked around a few years ago, the disparity would have been even greater,” says Michael Fitzgerald, the Iowa state treasurer and chair of the College Savings Plan Network. He was able to negotiate a better deal for his constituents as more people signed up for the plan: “In 1998 we were charging 68 basis points. Now we’re down to 28.”
It’s proof that states can negotiate better deals with money managers. If your state officials haven’t already done that on your behalf, let them know you think they can do better. Someday your child will thank you for it.
This story is from the October 28, 2013 issue of Fortune.