Picking the Right 529 Plan

Updated on March 26, 2009.

NOT ALL 529 COLLEGE savings plans earn top marks. Some have high fees and poor investment options. But a good 529 plan is still one of the best ways to save for college. (For a full tutorial on tax-free college savings plans, click here.)

How do you know which plans are worth your money? Follow these four tips.

1. Go It Alone
With more than 80 different 529 college savings plans to choose from, the task of picking the right one can seem overwhelming. Adding to the confusion, each plan comes with its own fee structure and investment options.

It's easy to see why some investors seek the guidance of a broker when selecting a plan. Approximately 40% of 529 plan sales in 2008 were conducted through a broker or financial adviser, according to the Financial Research Corporation, which tracks the industry. (That's down from 58% in 2006.) 

The problem is that going to a commission-based financial adviser can mean losing up to 5.75% of your investment to a commission, also known in the industry as a front-end load. That fee eats directly into your college stash, leaving you with fewer dollars once the tuition bills start rolling in.

The good news: Almost every state offers a no-load option in addition to adviser-sold plans. So with a little bit of research, you can find the best plan for your family and skip the broker fee, says Dan McNeela, a senior fund analyst at investment-research firm Morningstar.

2. The Home Court Advantage
Always check out your home-state's plan first, because it might come with a state-tax benefit. As of January 2008, thirty-four states plus the District of Columbia offer some sort of front-end tax incentive for in-state investing, says Certified Public Accountant Joe Hurley, who runs the handy Savingforcollege.com Web site. In many cases, that additional tax break will give your home-state's plan a decided advantage.

Actual tax breaks vary by state. Some offer a state-tax deduction on part or all of your contributions, while others provide a matching contribution up to a certain dollar amount. More recently, some states have started offering state-tax deductions even if you send your dollars out of state.

Just be sure to crunch the numbers to see how good a deal investing in your home-state's plan really is. For example, if your state-tax rate is 3% and you can deduct up to $3,000 of 529 plan contributions per year (of the states that allow a contribution deduction, most have some sort of a limit), your savings will be a mere $90. Illinois residents, on the other hand, can save a whole lot more than that: In-state investors in the Illinois plan can deduct up to $20,000 in contributions a year if married, $10,000 if single. Given that the state's tax rate is 3%, that translates into savings of $600 annually. This, in addition to the low fees charged by this plan, makes Illinois' plan a great choice for in-state residents.

Things get more complicated, however, if you have a state with tax benefits — but high fees. Take Nebraska, for example, where residents can deduct up to $5,000 of their contributions from their state taxes. This translates into savings of up to $128 a year for those in the state's lowest tax bracket (2.56%) and $342 for those in the highest tax bracket (6.84%). Meanwhile, the State's direct-sold plan charges management and underlying fund fees of up to 1.64% of assets, plus a flat $20 annual maintenance fee.

Given this, Nebraska residents who choose to invest in the plan's most expensive portfolios would most likely be better off skipping the state-tax break and going with a lower-cost plan out of state. (One important thing to note however is that Nebraska's plan is one of the best performing 529 plans, even after expenses, says Hurley.) For example, we compared the Nebraska and Illinois plans, using a one-time $4,000 initial investment and a 6% rate of return for both plans. After plugging in all the expenses, we calculated that if we made an additional $1,000 contribution each year for the next 10 years, the account held in Illinois' plan would grow to $20,434, while the Nebraska account would hold $18,678. That said, Nebraska's plan also offers lower-cost options, including age-based portfolios with expenses ranging from 0.78% to 1%.

You can run the numbers yourself using the NASD's 529 Plan Expense Analyzer. It will tell you how your investment will grow in two different plans, given their annual costs, projected rates of return and the potential tax breaks.

Meanwhile, investors who live in states that have no state tax or offer no tax benefits should simply shop for the best plans out there.

3. Fight the Fees
The fees charged by many 529 plans are ugly. Not only are they often outrageously high — they're also hard to understand.

Take, for example, Arizona's Family College Savings 529 Program and Oregon's MFS 529 Savings Plan, which can charge as much as 2.4% and 2.3% of assets a year, respectively, according to Morningstar. According to Harold Simansky, investment adviser at Brookline, Mass.-based Simansky Investments and author of "College Costs How Much?!," any plan that charges more than 1.5% should be considered "outrageous."

The good news: Cheap plans are becoming more readily available and can be found with low-cost providers like Vanguard and TIAA-CREF. To identify low-cost plans, look at their expense ratios. (If a plan doesn't list its expense ratio, it's not a plan you want to invest in.) McNeela's advice is to look for a range of 0.65% to 0.70% of assets when investing in a plan that's built around inexpensive index funds, and 1% to 1.1% for plans that use more expensive actively managed funds.

4. Review the Investment Options
One limitation of 529 plans is that they offer a limited number of investment options. At best, you might have roughly a dozen portfolios at your disposal. This typically includes some static portfolios that are 100% stock or 100% bond funds, as well as age-based portfolios that are a mix of stock and bond funds, which shift to become more conservative as college time approaches. The best offerings tend to be provided by well-known mutual-fund families like Vanguard, Fidelity Investments and TIAA CREF.

Unfortunately, evaluating the performance of these options is no easy task. Even in the prospectus, fund performance is rarely measured against any benchmark, and many of the portfolios are actually funds-of-funds, with no ticker for tracking purposes. For help, go to Morningstar's online guide to 529 plans, which at least tells what percentage of each 529 plan's underlying mutual funds have earned the highest Morningstar performance ratings.