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7 Things to Know About 529 Plans

Jeff Brown

Start studying college savings options and you'll soon see the term " Section 529 Plan." These awkwardly named programs are better than they sound, allowing investment in stock and bond funds with no federal tax on gains used for tuition and other approved college costs. Some states offer tax breaks as well.

So what's not to like?

The vast array of 529s, named for the federal statute that makes them possible, are not all created equal. Each state offers several investment options, and you are free to choose a plan offered by a state other than your own. Shopping is tricky, and the factors you take into account when your future college student is an infant could change down the road.

Still, tax-exempt investing is valuable enough to make research worth the trouble, explaining why 529s have become so popular. Total assets in investment-style 529 plans topped $234 billion last year, up from $8.6 billion in 2001, according to the Investment Company Institute, a trade group for the mutual fund industry. Over the same period, the number accounts soared to 11.1 million from 1.3 million.

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Shopping can be tricky. Start with U.S. News & World Report's 529 finder.

"You can spend loads of time researching and comparing state plans," says Julie Ford, a financial planner with Ford Financial Solutions in New York. "Don't stress out about this decision too much. The most important thing is the actual act of saving and opening up an account."

As with all investing, there is the risk of losing money, so it's important to shop around and think about the right balance between risk and potential reward. Some families opt to spread their risk by investing in plans from more than one state.

Here are seven things to keep in mind.

High contribution limits. As a practical matter, you can put as much into a 529 plan as you want, with lifetime limits typically in the hundreds of thousands of dollars. There are no limits based on the family's income, as there are with Coverdell Education Savings Accounts. Anyone can open a plan for any beneficiary, whether a family member or not.

529s are flexible. If your young student decides not to go to college or gets a full scholarship, the account can be easily shifted to someone else. In fact, the plan's owner -- a parent, grandparent or friend -- can even take the money back, though that would trigger income tax on gains and a 10 percent penalty for unapproved use.

You can also shift the investment from one option to another, or transfer funds from one state's plan to another's.

Tax deals vary. While all plans exempt profits from federal tax, each state has its own tax rules. In many, gains are free of state tax so long as you are a state resident, and in some contributions are deductible on the state return. Whether this is a significant factor in choosing a plan depends in part on whether your state has a heavy tax rate. If not, taxes may not be important enough to choose your own state's plan if another's has lower fees and better investing options.

"In Indiana, the state plan offers a 20 percent tax credit on the first $5,000 of contributions every year," says Nick Vail, co-founder of Wealth Advisors of Indianapolis. "You'd be crazy not to get a $1,000 tax credit by using an out-of-state plan."

Target-date funds make it easy. Increasingly, families are choosing the target-date option, which uses a heavy emphasis on stock funds when the child is young to emphasize growth, but shifts toward bonds to get more safety as the college years approach. Once the investment is made, the fund managers do the hard part, even rebalancing the holdings if market performance causes the mix of stocks and bonds to get off target.

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"Target-date funds allow parents to have a set-it-and-forget-it mentality, says Scott Patterson, a financial planner with Core Financial Resources in Anderson, South Carolina. "They will automatically adjust to a more conservative portfolio -- more bonds, less stocks -- as the target date approaches."

Prepaid tuition. As one investing option, some states allow participants to, in effect, pay for college credit hours at today's price, protecting them from future price hikes. While prepaid programs are not terribly popular, holding just $24 billion in assets last year, according to the Investment Company Institute, they appeal to families worried about inflation and the risks of the stock and bond markets. Usually, prepaid plans the are available only for state residents, but there typically are provisions for converting the assets to cash if the student chooses a different college than was designated at the start, or goes to school out of state.

Be sure to study the rules on that, and watch out for "premiums," which require you to pay more per credit hour than if your student were starting college right away. "Prepaid plans are becoming less and less common," Ford says. "Most people will benefit more from a savings plan."

Prepaid plans gain value as tuition rates rise, but a smart mix of stock and bond funds may well rise more over time.

Fees vary. Like all mutual funds, those in any 529 plan charge basic fees -- expense ratios -- to cover costs. The state or plan provider may charge other fees as well.

Brent Lindell, a financial planner with Savant Capital Management in Madison, Wisconsin, says some plans charge more than 1.5 percent a year, others less than 0.25 percent.

"I know that if I have less of an expense anchor on my kids' portfolio, I'm pretty sure that statistically, over the long term, I'm going to have a better return," he says.

Since small fees can take a big bite out of compounding over the years, study them carefully.

Direct sold versus broker sold. To minimize expenses, you can buy on your own, choosing a plan and dealing directly with the state. That's good if you are comfortable with investing decisions or choose a fire-and-forget target-date option. Many families, however, prefer to go through an investment advisor. That can mean paying a commission and possibly higher annual fees, so be sure ask about costs up front.

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Families that use a broker should generally avoid target-date funds, since those already provide professional management, says Jason J. Hamilton, president of KIS Fee-Only Financial Planning in Orange, California. A broker may choose a basket of index-style mutual funds with lower fees than the target-date option.



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