In 2012, assets in the plans grew 25% to $166 billion, according to Morningstar. Under the savings program, parents or friends of a child can invest in a fund and owe no taxes on the earnings, provided the money is used to pay tuition bills.
The 529 program can be a valuable resource for people who face tuition costs. But investors must shop carefully. Many of the investment choices are expensive and have delivered uninspiring returns.
According to Morningstar, the average 529 investment has underperformed conventional mutual funds. During the five years ending in January, the average mutual fund in the conservative allocation category -- which holds a mix of stocks and bonds -- returned 4.3% annually, compared to 3.7% for comparable 529 funds.
Part of the reason for the weak showing is that 529 plans charge extra layers of fees, says Morningstar analyst Kailin Liu. In a typical arrangement, a 529 fund invests in a portfolio of conventional mutual funds. So an investor must pay the expense ratios of the mutual funds. In addition, the 529 plans charge administrative fees. While the average moderate allocation mutual fund charges an expense ratio of 0.99%, a comparable 529 fund charges a total of 1.22%.
States sponsor the plans, and the fees vary considerably around the country. Among the lowest-cost plans is New York's 529 Program, which charges 0.17%, a total that includes administrative fees and expense ratios on the mutual funds in the portfolio. Near the high end of the spectrum is Iowa Advisor 529 Plan, with a total expense ratio of 1.74%.
The plans follow a variety of investment strategies. Among the most popular choices are conservative portfolios that keep a relatively static asset allocation. You start with most assets in bonds, and the allocation stays that way until the child enters college.
In another approach, the allocation is age-weighted, gradually becoming more conservative over time. So a portfolio for a four-year-old might have 80% of assets in stocks. By the time, the child reaches 19, the fund will only have 10% of assets in stocks. The thinking is that savers cannot afford to hold risky stocks near the time when tuition checks are due.
You are free to invest in any state program you want. But some states provide big incentives to keep savers at home. Indiana offers tax credits of up to $1,000 annually for state residents who invest in the local program. Some states say earnings in 529 plans are free from state taxes, provided that the money is invested at home. If you live in a state like Texas, which has no state income taxes, there is no tax incentive to stick with the home state program. So you can shop for the investment that suits your taste.
A top choice is the Maryland College Investment Plan, which holds a basket of T. Rowe Price mutual funds. The Maryland age-weighted portfolio that is designed for youngsters who will attend college around 2018 has about 56% of assets in stocks and most of the rest in fixed income. The allocation is a bit more aggressive than its average competitor, which has 52% of assets in equities. The stock-heavy approach has boosted returns.
During the past 10 years, the Maryland portfolio returned 8.4% annually, while the average peer returned 7.2% annually. The portfolio has 22% of assets in T. Rowe Price Equity Index 500 and 6.8% in T. Rowe Price Blue Chip Growth . About 47% of assets are in T. Rowe Price Spectrum Income , which holds a mix of bond funds.
Another strong choice is Utah Educational Savings Plan. The program invests primarily in Vanguard index funds. By sticking with low-cost investments, the plan offers total expenses as low as 0.18%.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.