If you participate in a 401(k) plan, chances are you've heard of target-date funds.  Perhaps you've even been told that your contributions will default to such a fund if you don't specify otherwise.  In the last few weeks I've worked with employees of at least 4 employers for which this is the case.  All in all, more than 70% of 401(k) plans now offer target-date funds, and for various reasons they are often the default option for new participants in the plans.  Another popular use of these funds is in 529 plans for college savings.

So...what is a target-date fund?

A target-date fund is a mutual fund that invests in multiple asset classes in a way that is designed to be appropriate for a time horizon defined by the fund.  The asset mix changes to become more conservative over time, as the target date gets closer.  This change in asset mix over time is commonly referred to as the glide path.  Because it invests in multiple asset classes, such as various classes of stocks and bonds, and alters the asset allocation over time, the target-date fund is really designed to be a portfolio unto itself.  In practice, such funds will typically invest in several other mutual funds, each of which is dedicated to a specific asset class.

Challenges of target-date funds

Probably the most significant over-riding challenge associated with target-date funds is the fact that many consumers group all such funds together.  I think most tend to understand the difference between a fund targeted at, for instance, retirement in 2015 vs. retirement in 2040, fewer seem to distinguish between the 2040 offering from Vanguard and the 2040 offering from T. Rowe Price or Fidelity.  These funds are not necessarily managed in a similar manner.  Asset allocations will likely differ, and the underlying funds that the target-date funds own will certainly be different.  A recent Government Accountability Office (GAO) report found that the performance of these funds varies widely from family to family.

More specific criticisms include:

Expenses - Target-date funds typically charge fees at the fund level, including a management fee to cover the effort associated with defining the asset mix and selecting underlying funds in which to invest.  Of course, these underlying funds charge fees of their own, which results in the layering of fees.  The underlying funds are often index funds, and the associated fees can be relatively inexpensive.  That's not always the case, though, and it takes some digging to unearth the total cost of investing in target-date funds.

One-size-fits-all approach - The fact that two individuals plan to retire in the same year does not mean that an identical investment approach is warranted.  Among other things, they may be different ages, and may have different levels of risk tolerance.

Investments - The fund family that manages a target-date fund will typically look to invest in funds from within the same family.  For instance, Fidelity will invest in Fidelity-managed funds, the MFS Lifetime funds invest in other MFS-managed funds, etc.  Without trying to indict a specific fund family, there may be an incentive to use less popular and less successful funds within the target-date funds.

Are they good for anything?

I think the best argument in favor of target-date funds is that the better ones serve as a reasonable default option for investors who will not otherwise put forth the effort to select funds in a methodical manner, according to an allocation that makes sense for them.  If they prompt people to save who otherwise wouldn't, regardless of the reasons, they are probably serving a valuable purpose.  Regardless, this is an increasingly broad category of products, and to really ensure that a target-date fund is a reasonable option requires some digging.  

The quick answer is yes, 529 accounts can be rolled into new 529 college savings plan accounts.  There are several rules that must be followed to avoid unwanted taxation and penalties, but they’re not particularly complicated and shouldn’t be an obstacle to shifting funds in this manner.

Why would somebody want to roll over funds to a new plan?

Before we get there, though, you may be asking why somebody would want to roll over a 529 account.    There are a several reasons that make sense to me.  These plans are not all created equal, and they change from time to time.  It’s possible that a family initially chose a plan without realizing that it had high fees and/or poor investment choices.  Upon learning that better options exist, they decided to make a change.  In many cases, in fact, brokers sell plans that are not really the best option for the purchaser.  They’re sold because they are a good option for the broker, even if it means that customers forego a state tax benefit because they’re buying a plan that is administered by another state.
Another basic reason that a rollover would make sense is that people move, and there may be new state tax benefits offered in their new home state.  That is certainly worth investigating, in any case.

What should I be aware of?

As long as a 529 account has not been rolled over for the given beneficiary in the previous twelve months, there are no negative consequences to rolling it over.  This is true even if the accounts have different owners.  If the beneficiary has had an account rolled within the previous twelve months, it can still be done, but the beneficiary has to be changed.  The beneficiary can then be changed back at a future date without no adverse consequences.

One key consideration

There may be state income tax consequences to rolling over a 529 account.  Certain states may seek to recapture any state tax benefit that was previously received on contributions.  Similarly, they may just treat it as a nonqualified distribution for state income tax purposes.

What if it’s done wrong?

The worst-case scenario if the process isn’t executed properly is that it will be considered a nonqualified distribution for federal taxes, which would also add a 10% tax penalty to all earnings in the account.  There also could be gift tax considerations.  The good news is that this shouldn’t be too hard.  As with retirement account rollovers, doing a direct, trustee-to-trustee rollover is a good way to stay out of trouble.

In the very first post of this blog, I talked about 529 plans and why I thought they were the best way for most parents to save for college.  That was more than five years ago.  In some ways, much has changed since then.  The crash of the markets in 2008 led to lawsuits and the restructuring of a lot of individual state plans.  Generally, this restructuring led to better investment options and lower fees, such that the bad plans started looking more like the good ones.

The basic regulatory structure has remained the same for 529s, although there have been some notable developments over the past few years.  Perhaps the most significant of these is that the Pension Protection Act of 2006 made permanent  tax-free withdrawals from 529 plans, for qualified educational expenses.  This didn’t come as a big surprise, but it removed an element of uncertainty that made these plans even more popular.  In 2009 and 2010, the costs of computers and other computer technology for college students were included as qualified expenses, but that provision expired on December 31, 2010.

An obscure decision in 2006 undoubtedly increased the value of 529 plans for contributors.  It was made by a regulator of the plans, and specified that brokers must inform customers that they may be eligible for state income tax breaks if they invest in their home state.  Ameriprise Financial Services was fined for selling clients only one plan (which presumably compensated them handsomely) regardless of where the client lived and what tax benefits were available for the clients.

One of the questions that I often get about these plans pertains to what happens if the beneficiary receives a scholarship and doesn’t need all of the money that has been set aside.  It’s probably notable that a much less frequent question involves what happens if the beneficiary chooses not to go to college.  In any case, there are a couple of options in the case of a scholarship.  One is that the funds can be ported to another beneficiary, such as a sibling, without any consequence.   If there are no siblings, or they all receive scholarships, an amount equal to the scholarship award can be withdrawn from the 529 account without penalty.  Taxes will still be due on the funds that are withdrawn.