Using ETFs in Clients’ 529 Plans and Education Savings Conversations

The average cost of college tuition and fees at public four-year institutions has risen 141% over the last 20 years—at private universities, that figure is 181%, according to the Education Data Initiative. Given that education costs have also outpaced inflation by an average of 104.3% annually, it’s easy to see why your clients may be feeling the pressure to plan smarter and start earlier.

For families saving for college, 529 plans are the gold standard. Traditionally, 529 plans have featured mutual fund-based portfolio options, but an increasing number of 529 plans now offer exchange-traded funds (ETFs). The availability of new ETF-based portfolios presents an opportunity for advisors to explain the affordability, flexibility, and transparency of ETFs, as well as how, when strategically positioned in a tax-advantaged account, they can help clients achieve their financial goals. 

Why ETFs Work for Education Savings

ETFs were created to combine the best features of mutual funds and individual stocks, putting the benefits of long-term growth opportunities, diversification, transparency, and affordability into a single vehicle.

Low Cost

The expense ratios for ETFs are typically lower than those for mutual funds because of their structure. ETFs, particularly those tracking indexes, are not actively managed. Without an extensive research team trying to beat the market, ETF fund managers can keep expense ratios lower. The savings over mutual funds are not huge, but even a slight difference in fees can have a significant impact on net returns.

For example, a $100,000 investment over 15 years with an average annual return of 7% and an expense ratio of 0.03% would reach a value of $274,745. The same investment with a 1.0% expense ratio would end up at $239,656—$35,089 less, due to fees.

Diversification

ETFs offer investors opportunities for diversification across companies, sectors, countries, and asset classes, eliminating the need to manage hundreds (or even thousands) of individual stocks. This one-click diversification enables investors to maintain their path to achieving their goals with reduced risk and increased simplicity, without having to pick every winner and loser along the way.

Tax Efficiency 

Contributions to 529 plans are made with after-tax dollars, grow tax-deferred, and allow for tax-free withdrawals for qualified education expenses. ETF-based 529 plans take this tax efficiency one step further, thanks to their structure and the way 529 plans handle capital gains distributions.

Many 529 plans redeem shares “in-kind” with institutional investors, rather than selling shares and buying new ones. This means there’s no taxable event and no capital gains distribution to investors. By law, mutual funds must redeem shares at net-asset value, and those capital gains get passed on to investors in the fund.

Transparency and Liquidity 

Many mutual funds only report their holdings quarterly or monthly, while most ETFs disclose their holdings daily. This gives investors better visibility into what they own. In addition, 529 plan reallocation rules determine how often investors can change their holdings.

Most ETFs for 529 plans are highly liquid, and ETFs are adjusted as needed to ensure the funds maintain their intended asset allocation and risk profile. 

Choosing the Right ETF Mix Based on Time Horizon

As your client’s children approach college age, their 529s need to grow and change with them. This transition is very similar to the one that occurs in many retirement portfolios, except education savings accounts must shift within a much shorter time frame.

Many ETF-based 529 plans offer target-date allocations, but these one-size-fits-all approaches won’t work for everyone. You should guide your clients through this process and shift risk appropriately along the way by using a mix of different ETFs with varying goals and outcomes. 

Young Children (15 or More Years To College)

During this period, growth and wealth accumulation are the name of the investing game. Portfolios should focus on equity, broad-market ETFs that focus on growth over income: 

• Equity ETFs: Broad or total-market ETFs like the iShares Core S&P 500 ETF 529 Option (IOVAX), which tracks the S&P 500 index, offer scalable growth based on the market, rather than relying on any one stock. These funds are instantly diversified, which lowers risk across the board while providing ample room for the portfolio to grow. International equity funds may further diversify these 529 portfolios and help them grow during the early years of education savings. 
• Thematic ETFs: These ETFs, which focus on niche sectors of the market such as technology, energy, healthcare, biotechnology, and emerging markets, may be suitable for investors with complementary risk tolerances. Thematic ETFs have more risk and generally higher fees than broad market ETFs, but the trade for growth potential in a pre-diversified basket of funds might be worth it. 

Kids in Late Elementary or Middle School (8 to 14 Years to College)

The period of eight to 14 years until college is a good time to start reallocating a portion of an education savings portfolio to funds focusing on capital appreciation, reducing risk while maintaining growth potential:

• Bond ETFs: Compared with the growth of many broad market ETFs, bond ETFs may seem a bit bland to clients, but they play a crucial role in transitioning an ETF-based portfolio to the withdrawal stage. In 529 plan portfolios, they offer guaranteed income and a shift away from market risk, without requiring investors to manage multiple fixed-income holdings.
• Low-volatility smart beta ETFs: The low-volatility ETF structure sits between actively managed funds and traditional index funds. These funds adhere to the standard ETF structure, which involves diversification and reallocation based on the index’s desired outcome. However, in low-volatility ETFs, fund managers seek stocks that offer steady potential for growth, but with fewer fluctuations over time.

Kids in Middle School/High School Aged Children (0 to 7 Years to College): 

As children approach the need for their higher education funds, the importance of capital preservation in achieving their long-term goals becomes increasingly critical. It’s during this time that you should guide your clients toward guarding what they’ve built, as they don’t have as much time to recover from market losses: 

• Dividend ETFs: The primary purpose of these funds is to identify stocks that reliably pay dividends to investors. This provides income stability with some growth potential as the 529 plan portfolios near the point of withdrawal. 
• Conservative ETFs: These are typically a hybrid investment vehicle that combines stocks and bonds. Conservative ETFs focus on steady growth rather than sizzle. The bond holdings anchor the portfolio with guaranteed income while also having the potential for measured, yet meaningful growth for portfolios with a short runway to withdrawals. 

Where Financial Advisors Add Value For Their Clients

Without an advisor’s guidance, ETF-based 529 plans may lead to investor analysis paralysis, and many might default to an age-based or target-date fund when better options are available for their specific goals. That’s where an advisor can elevate the conversation and use client-specific strategies, accounting for their kids’ ages, timelines, risk tolerances, goals, the state where the parents gain income, and tax considerations: 

Glide path evaluation: An age-based portfolio may be suitable for your client’s timeline, risk tolerance, and goals. However, you should carefully assess the glide path’s aggressiveness or conservativeness and help them take an active role in adjusting it for market conditions or changing circumstances. 

Goal integration: Education savings may be a priority for your clients, but it’s doubtful that those same clients will tell you that their retirement plan is to rely on the kids whose education they’re paying for. Therefore, education savings is only one piece of an overall financial plan, even as almost a quarter (24.4%) of the savings parents use for college comes from their retirement accounts, with another third (31.5%) coming from other savings and investments, not 529 plans. Advisors can help guide clients, especially those with limited resources, to allocate funds to education savings without neglecting their retirement needs and other financial priorities. 

State-by-state plan selections: 529 plans are state-sponsored, but clients may use any state’s plan. Some states offer better ETF-based 529 plans, based on features such as cost, fund selection, and governance. However, using an out-of-state plan may leave tax deductions or credits on the table for some investors. Advisors can add value here by comparing out-of-state options with in-state options, considering each plan’s features and any favorable tax deductions or credits. 

Tax strategies: Like all tax-advantaged accounts, 529 plans have specific rules, including contribution limits, guidelines for qualified versus nonqualified withdrawals, and restrictions on using leftover funds. Without an understanding of the associated rules and tax implications, clients may overcontribute or make unwise withdrawals.

The Bottom Line

ETF-based 529 plans offer clients a cost-effective way to grow and maintain college savings as higher education costs rise at a rate that often significantly outpaces inflation. However, the real power of ETF-based 529 plans lies in pairing them with personalized strategies that account for an investor’s risk tolerance, timeline, and goals.

As an advisor, you can demystify the numerous options available to clients for their 529 plans and tailor strategies that reflect their evolving circumstances.