*Guest post by Vered DeLeeuw

Last week we wrote about the risk factors in 529 plans. This article explores some further considerations when choosing a 529 plan while also explaining some basic concepts of this often overlooked college savings tool.

A 529 plan is a tax-advantaged savings plan designed to encourage and facilitate saving for future college costs. 529 plans are usually sponsored by states and are authorized by Section 529 of the Internal Revenue Code.

The main incentive for using 529 plans is the tax advantage they offer over regular taxable accounts. The funds in a 529 plan grow tax-free if they are used for college tuition and expenses. Many states, but not all, also allow a tax deduction or credit when the funds are contributed to a state-sponsored plan of the account owner’s home state.

State Tax Break

All 529 plans are open to residents of all states. You don’t have to invest in your state’s plan. Of course, if your state offers a tax deduction, that would be an incentive to use its 529 plan – but there are considerations other than the state tax deduction when it comes to choosing a 529 plan. So if your state plan offers a tax deduction but has high costs, it’s not necessarily the best option.

For example, since the California plan does not offer a state tax deduction, and its expenses can get as high as 1.06%, California residents might do better by investing in cheaper, out-of-state 529 plans.

Cost

Research has repeatedly shown that when it comes to mutual fund investing, cost is the most important factor in determining a fund’s performance. The same is true for 529 plans, which charge their own fees in addition to the fees levied by the underlying mutual funds. In the vast majority of cases, the lower a plan’s fees are, the better its long-term performance will be.

Utah’s plan has some of the lowest overall costs in the nation at 0.00% to 0.34% annually. Illinois’ Bright Start College Savings Program also offers low fees.

Fund Selection

Most 529 plans offer age-based portfolios, in addition to a selection of funds for those who prefer to create their own investment mix. The best 529 plans offer a wide selection of stock and bond funds to choose from, from reputable fund families such as Vanguard and Fidelity.

A good example is the Nevada Vanguard 529 Savings Plan, which offers a wide selection of choices. The age-based option offers a choice among three different risk levels (Aggressive, Moderate, or Conservative), each containing five portfolios of underlying mutual funds. Static investment options include five multi-fund portfolios (Aggressive Growth, Growth, Moderate Growth, Conservative Growth, and Income) and 14 individual-fund portfolios. Total annual expense ratio is fairly low too, at 0.25% – 0.55%.

Age-Based Portfolios That Make Sense

Most 529 plans offer age-based portfolios. Personally I don’t use them, but if you prefer the convenience, you should make sure the preset asset allocation gradually advances from aggressive to conservative as the child nears college age. We noted in our previous post on 529 plans that some age-based 529 plans had lost nearly half their value in 2008, even though the beneficiaries were very close to college age, because the asset allocation had remained too aggressive.

Conservative Options

A good 529 plan should offer conservative options in addition to stock and bond funds. For example, the Michigan Education Savings Program offers a principal- protection option based on a Treasury note index, which does not charge an annual fee.

While using a conservative option too early could mean your college savings would not grow enough to cover future college expenses, it does make sense to move to such a plan as your child nears college age.

Stay Away From Advisor-Sold Plans!

Many states offer a 529 plan sold by an advisor in addition to the one that can be purchased directly by the consumer. I’m not a big fan of the advisor-sold plans because they charge load fees. If you’ve ever read any of my articles, you know exactly how I feel about loads. Simply put, advisor-sold plans create wealth for the advisor at the expense of the beneficiary, so always choose a direct plan.

529 plans offer investors a great tool to fund college using tax-advantaged growth, but it’s important to choose wisely. Never assume that your state’s plan is your only option. Look at direct plans only, and from those, try to choose plans that are low-cost, offer state tax incentives, and have a good selection of funds.

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