529s: Best savings plan gets better

The last doubts about 529 plans have been erased. So, college savers, what are you waiting for? Here's our guide to the best of the bunch.

By Penelope Wang, Money Magazine senior writer

NEW YORK (Money Magazine) -- For years, consternation over expiring tax breaks, questionable financial aid treatment and high fees cast a long shadow over 529 plans, the once and future king of college savings accounts.

Not anymore. Consider these recent developments:

  • Over the past year Congress has made tax-free withdrawals from these accounts permanent (they had been slated to end in 2010).
  • Clarification of the financial aid rules has put to rest concerns that the plans can hurt eligibility for grants and low-cost loans (they may help).
  • And many 529 providers have cleaned up their acts, slashing expenses and upgrading their investments.

The alternatives to 529s, meanwhile, are looking grim. Custodial accounts? Sunk by the latest hike in the kiddie tax. Coverdell Education Savings Accounts? An impending drop in contribution limits to just $500 a year will barely allow you to fund your kid's pizza budget.

The upshot: You'd now be a fool to save for college any other way but in a 529 plan.

Faced with such a clear choice, parents (and grandparents) have been pouring money into these plans lately - a record $5.2 billion flowed in during the first quarter of this year alone.

You will certainly need every penny you can sock away. With college costs in recent years climbing at a 6% annual rate, four years of tuition, room and board at a public school will run you $125,000 by 2022; for a private college, you'll need closer to $300,000.

The real question then is not whether to save for college in a 529 account but which one to pick. There are some 85 plans available nationwide, with almost every state offering at least one program and some, like West Virginia, offering as many as five.

The number and quality of the investment choices vary, and some of the plans are a whole lot more expensive to buy and own than others. Depending on where you live and which plan you pick, you might qualify for a state income tax deduction on your contribution.

Then again, the rules governing those write-offs may be changing soon. And many of the plan managers could change over the next few years as well, since some 60% of state contracts with their current 529 providers are set to expire by 2010.

Confusing? Well, yes. But it's nothing you can't handle by adhering to a few simple guidelines.

Rule 1: Look first at your own state plan

All 529 savings plans provide the same federal tax benefits: Your investment earnings grow free of income tax. Your withdrawals, as long as you use them to pay higher education bills, are untaxed as well.

What you don't get is an up-front federal tax deduction - think of these accounts as the college saver's counterpart to Roth IRAs.

But 32 states and the District of Columbia have stepped in where the feds have not, offering residents a write-off on state income taxes for at least a portion of their 529 contributions.

And three states - Kansas, Maine and Pennsylvania - even allow residents to deduct their contributions to out-of-state plans as well.

If you live in a high-tax state that offers a big deduction for 529 contributions, your best 529 plan is one in your own backyard - that is, as long as the plan also has reasonable expenses and offers solid investment choices (see rules 2 and 3).

In New York State or Michigan, for example, a married couple filing jointly can write off contributions of up to $10,000 ($5,000 for single taxpayers). And in Colorado, New Mexico, South Carolina and West Virginia, your contributions are fully deductible no matter how much you put in. (To see how much you can save in state taxes, check the calculator at archimedes.com.)

We selected 22 plans as top choices on this basis, in addition to another 5 whose strong management and low fees make them top choices not only for their own state's citizens, but for anyone whose in-state plan doesn't merit a star.

Outside those states your tax break may be modest - or your state may not offer a deduction or even impose an income tax at all. In that case, expand your search to include out-of-state plans.

One caveat: The rules governing state deductions for 529 plans could be changing soon because of a pending Supreme Court case that may bar states from giving tax breaks to their own 529s but not to out-of-state plans. (The case, Davis v. Kentucky, involves the tax treatment of municipal bonds, but 529 plans are likely to fall under the same rules.) A decision isn't expected for several months. But if the court does rule against special tax treatment, states may respond either by allowing residents to deduct contributions to any state's plan or by dropping their write-offs altogether.

For now, however, there's no reason not to grab the tax break for as long as it may be available.

Rule 2: Keep your expenses low

High management, marketing and administrative fees can cancel out the tax savings on 529 accounts and drag down your returns. For years the plans got a bad rap for charging too much, but growing competition lately has pushed many providers to lower their fees, says Joe Hurley, head of Savingforcollege .com, which supplied the data for our 529 survey.

For example, TIAA-CREF recently reduced fees on its Michigan plan from 0.60% to 0.45%. Last year Vanguard cut costs on its Nevada 529 to as little as 0.5%, while Fidelity began offering low-cost index funds in several plans, like those in California and Massachusetts.

But many 529 plans still charge you far more than you'd pay if you bought the same fund directly from the fund company. That's particularly true of plans sold through brokers.

The expenses for Missouri's MOST 529 Advisor plan, for example, range as high as 3.45%, or nearly three times the cost for a typical retail stock fund.

You will typically find the lowest costs among direct-sold 529s, such as Utah's Education Savings Plan, with expenses of 0.38% or less.

Try to limit your choices to in-state plans that charge less than 1% or national plans with expenses below 0.7%.

Rule 3: Pick funds that match your style

In addition to lowering their fees over the past year, 529 plans have been overhauling their menus of stock and bond funds by adding index portfolios as well as actively managed options.

For example, Colorado's Scholar Choice plan now allows investors access to star manager Bill Miller, who has beaten the S&P 500 in 15 of the past 16 years.

Still, most families favor age-based portfolios, which work much like target-date retirement funds in a 401(k). You select a mix of funds that gradually adjusts its allocation from stocks to fixed-income assets as your child nears college.

"Unless you are confident that you will make regular asset-allocation moves yourself, an agebased fund is the best option," says Michael Steiner, a financial adviser in Chatham, N.J.

Today many 529s offer three or four age-based mixes that range from aggressive to conservative; pick the one that suits your tolerance for risk.

A moderate investment allocation for an eight-year-old, for example, might be a 60-40 mix of stocks and bonds. If you decide to manage your own portfolio, remember that you can make an investment change only once a year.

Rule 4: Perform an annual checkup

A parent's duties are never done. Once you have signed up for a 529, you should review your account at least once a year to make sure your investments are on track.

And watch out for changes in your state's provider. If your plan does switch, look closely to make sure the expenses are still reasonable and the fund choices are solid. If you decide to stay in the plan, your account will be automatically shifted to a similar offering at the new fund group unless you request otherwise.

If you don't like the change or decide to move for other reasons, it's easy to switch to a different 529 in your state or another one. You are allowed one rollover a year. Just fill out a form. Most 529s will process the transaction within a week.

Rule 5: Plan you exit strategy

Making a withdrawal from your 529 is just as easy. By filling out a form, you can even arrange for the money to be sent directly to your child's college - a move that can simplify your tax records.

Be aware that under IRS rules, the payment of expenses and the withdrawal of 529 funds must take place within the same calendar year to qualify for tax-free treatment. In other words, you can't use money you withdraw in 2007 to pay a tuition bill in 2008.

Keep receipts, in case the IRS asks, to show that you spent the money on qualified education bills, which include tuition, room, board and fees.

Unfortunately, student-loan payments don't qualify. Still, with any luck, by saving in a 529, you may not have big college loans to worry about. Then again, there's always graduate school. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.