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How to Find a Great 529 Plan to Pay for College

When it comes to saving for college, Section 529 plans are easy to understand in principle, but devilishly tricky when it comes to shopping.

The plans allow parents grandparents -- or anyone, for that matter -- to invest for a child's college education and avoid federal taxes on gains. But there are hundreds of options, and because the plans are offered by state governments, it can be very difficult to figure which one would serve a particular family the best.

"An investor can live in South Carolina, invest in a plan from Nevada and send a student to college in Georgia," says Michael A. Faust, vice president of Raymond James's Faust-Boyer Group in Greenville, South Carolina.

[See: 11 Tips for the Sandwich Generation: Paying for College and Retirement.]

"In my experience 529s are the best thing since sliced bread while saving for college," says Scott Vance, an advisor at Trisuli Financial Advising in Cary, North Carolina. "The generous contribution limits -- set by each state but generally equal to the four-year expense -- far outweigh a Coverdell education savings account (with a $2,000 annual limit.) The ability for the funds to grow tax-deferred and tax-free if used for qualifying college expenses are a tax advantage that is almost insurmountable."

Every year, Morningstar, the market-data firm, publishes a list of plans it considers the best and Morningstar's criteria underscore factors that should be most important to shoppers. While investors choosing among mutual funds and exchange-traded funds typically look at past performance and fees, this does not work as well with 529 plans because each family must plan for its student's unique college start date. Many plans use target-date funds that gradually shift to more conservative holdings as the date approaches, making past performance uninformative.

So, rather than focus on performance, Morningstar looks at things like the quality of the underlying investments (typically a set of mutual funds), the process the plan uses to select investment managers, how the plan allocates its assets, the fees it charges, the oversight from the state and the range of investment options offered participants.

Many states offer plans in two flavors: ones sold by financial advisors, and "direct-sold" plans with lower fees that the investor obtains directly from the financial services firm like Vanguard or T. Rowe Price that manages the plan. All four of the plans receiving Morningstar's top, or gold, rating this year, are direct-sold: the Vanguard 529 College Savings Plan from Nevada, the Utah Educational Savings Plan managed by the state, the Maryland College Investment Plan managed by T. Rowe Price, and the T. Rowe Price College Savings Plan in Arkansas.

"Advisor-sold funds could cost you thousands of dollars in commissions over time and offer no clear benefit," says James Kinney, owner of Financial Pathways Advisors in Bridgewater New Jersey. "We advise clients to choose a low-cost provider such as Vanguard or T. Rowe Price, find the page to open a college savings account, and choose a simple target-date fund based on the child's age. It takes no more than 30 minutes. Using an advisor to open a 529 for you is like calling an electrician to flip a circuit breaker. If you don't know how to do it, it will only take you a few minutes to figure it out."

There are many good plans with annual fees totaling less than 0.2 to 0.4 percent of the account value, according to Jamie Canup, a tax expert at the Hirschler Fleischer law firm in Richmond, Virginia.

Among the criteria to consider:

State taxes. Many states offer state income tax deductions for contributions if the donor or beneficiary are state residents. Some also offer state deductions on investment gains.

[Read: How to Save for Retirement While Paying for a Child's College.]

"Even if your state's plan is not top rated, it may be worth staying local if you get a deduction on your state taxes," Kinney says.

Aggressiveness. As mentioned, many plans offer a target-date option heavy on stocks for young children and moving to bonds and cash as the college years approach. But many of the same states also offer straightforward investments in baskets of mutual funds. With that approach, it will be up to you to decide whether to switch to more conservative options as time passes.

"You will want to consider seeking higher returns when the beneficiary is young and college costs are still relatively far in the future, so that risks are more easily borne," says Laurie Samay, a planner with Palisades Hudson Financial Group in Scarsdale, New York.

She recommends all stocks until the child is 12, then shifting 10 percent of the portfolio each year to something conservative such as bonds and cash so the plan is 100 percent safe for the student's last year of college.

Details. What if your child gets a swimming scholarship, doesn't go to college at all, or goes to a service academy for free? Most plans provide for this by allowing the plan owner to name a new beneficiary. But it's important to know how before you commit.

Gains not used for college are taxed as income and subject to a 10 percent penalty, Kinney says.

Transfers. Not only can you switch from one investment option to another within a given state's plan, you can transfer your assets to another state's plan without being taxed on your gains (though you may have to repay a state tax deduction you'd received).

The best way is to have your new plan deal directly with the old one. If you have money sent to you, the new plan must be funded quickly to avoid tax, and you'll need good records.

Prepaid tuition. Some states offer a chance to, in effect, pay for college at today's price to avoid the increases that will come before your student starts.

Though stocks have traditionally gone up faster than tuition, this prepaid option is useful if you worry about skyrocketing college costs.

Be sure to know how the value of your prepaid "credits" is determined, and watch for language that implies guarantees that aren't supported in the fine print.

Ownership. "Assets should be parent-owned, not child-owned," Kinney says, as a child's assets do more damage to eligibility for financial aid. "The child is beneficiary. Parental assets are assessed at a lower rate when filling out financial aid forms."

[Read: 7 Common Misconceptions About 529 College Savings Plans.]

A plan owned by a grandparent, or anyone else not in the child's immediate family, doesn't hurt aid eligibility at all.

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