Choose Your 529 Savings Plan Carefully

You already understand the benefits of a 529 College Savings Plan. In 2002 and beyond, you can use any growth in the 529 Plan tax-free for Qualified Higher Education Expenses such as tuition, mandatory fees, books, room and board. Plus, you, the account owner, not the beneficiary (your child say) maintain control over the use of the funds in the plan even though the dollars are out of your taxable estate.

But with nearly every state offering one or more 529 plans, how do you choose the best one for you and your beneficiaries? And once you have chosen a 529 plan, how do you choose among the investment options? Relax. There are many good plans available and it is not difficult choosing one.

First, I recommend to clients that they look at any plan offered by their own state. Many states offer tax incentives for residents to contribute to the state plan. Typically, the incentive is in the form of a state income tax deduction, so residents of states that have no income tax (such as Texas where I live) do not have this incentive. If you live in one of the many states that offer this tax deduction to residents and you qualify (check for any income limitations), you have a strong incentive to use your local plan.

Second, I believe that costs matter. 529 Plans include fees and expenses that affect the performance of the investments in the plan. These fees and expenses run as low as .5% to as high as 2% or more of the amount invested in the plans. The fees and expenses cover the cost of administering the plan and the cost of managing the underlying investments. I recommend that clients look at lower cost plans such as those administered by the no-load mutual fund companies Fidelity Investments, T. Rowe Price, and Vanguard, as well as, TIAA-CREF, the big pension fund company. Avoid plans sold by stockbrokers and insurance agents that have additional fees or sales charges.
Do fees matter much? Consider that we might expect an 8.5% average annual rate of return of the investments in a 529 Plan over a 10 to 15 year period while the average cost of attending college inflates at close to 5.5% a year. This results in a 3% "real" (inflation-adjusted) return per year for the underlying investments. Now subtract the expenses of the plan. At .5%, this leaves a return of 2.5% a year, while at 2 % it leaves only a 1% return. One and a half percent may not sound like much, but it can make a big difference. Over 15 years on a $50,000 investment, an extra 1.5% growth results in $12,511, perhaps enough to take care of room and board for an academic year.

Third, choose a plan with a managed allocation option, most plans have them although they may use different names for this option. The managed allocation option uses the age of the beneficiary to determine how aggressive or conservative the investments should be for the beneficiary. When the beneficiary is young, contributions and accumulations are invested primarily in stocks. As the beneficiary gets older, a greater proportion of dollars are allocated to bonds and cash equivalents (money market funds, fixed investments, etc.). Professionals using long-term historical data have designed these managed allocations. Many plans now permit you to customize the percentages of stocks, bonds, and cash-equivalents. You might do better designing the mix yourself, but the odds are against you, and you will likely be taking on more risk of not meeting your investment goals along the way. So I recommend that clients use the managed allocation option.

Finally, special issues can affect the choice of plans. Some state plans allow you to set up a custodial account (when monies are transferred from a Uniform Gift to Minors Account, for example), in which case, the minor (beneficiary) becomes the account owner at the age of majority (18 or 21 in most states). Other states do not permit custodial accounts. If you expect to need funds that are invested in the 529 plan within a short time frame (one to two years say for your high school senior), check to make sure that the plan you choose allows dollars to be withdrawn within that time frame. Many plans do not permit withdrawals for one or more years. Also, plans differ in the maximum contributions that can be made for one beneficiary from $100,000 to $235,000. So if you expect to put a large amount in the plan, chose one with a high limit.

These guidelines will help you chose the right plan. For an up to date list of 529 Plans, go to www.savingforcollege.com. This site permits you to compare the many good plans available today.

The author is a financial planner with Austin Asset Management, a fee-only financial planning and asset management company in Austin, Texas.