Grow a bigger college fund

  @Money January 16, 2014: 10:49 AM ET
529 fund

To earn the best returns on college savings accounts, you'll need to weigh tax breaks vs. better performance and lower costs.

(Money Magazine)

For much of the past decade, saving for college has felt a bit like throwing money down a rat hole.

To take advantage of lucrative tax breaks, your best bet was to invest via a state-sponsored 529 savings account (named after the section in the IRS code that created it). Yet many of the plans were less than ideal investment vehicles, featuring expensive, poorly managed portfolios that in most years failed to beat comparable mutual funds and market benchmarks, which in turn made it difficult for parents to keep ahead of skyrocketing tuition.

The financial crisis really exposed the plans' flaws: The typical plan for 7- to 12-year-olds lost about 28% the year of the crash, according to Morningstar, while some supposedly conservative funds for teenagers approaching college fell nearly 30%.

Discouraged parents, take heart: The recent bull market has restored the balances of many 529 accounts that had been hammered by the 2008 meltdown and then some -- over the five-year period that ended last November, the typical moderate 529 portfolio for 7- to 12-year-olds averaged solid gains of 12.4% annually. Combined with a slowdown in tuition price hikes -- last year's 2.9% increase at public universities was the smallest in nearly three decades, the College Board reports -- this improved performance is allowing many parents to finally make real inroads in saving enough to cover college costs.

Related: How much will that college really cost?

Best of all, says Savingforcollege.com founder Joseph Hurley, the plans themselves have improved dramatically. "Fees are much lower, and most 529s now have a broad range of 10 to 20 investment options -- some even better than what's available to the general public," he says. "We're in a good spot now."

That doesn't mean you can simply throw some money into your state plan, sit back, and expect great results. To maximize returns on your college fund, you need to weigh the tax benefits of staying in state against the costs and performance prospects of outside plans, and take an active role in selecting the investments that seem most promising, given your child's age and your own risk tolerance, from among the many choices now available.

Investing for a teenager? You also need to take extra steps to protect the portfolio against the imminent threat that rising interest rates could cause some usually conservative investment choices to lose value. Otherwise, you could find yourself running short, just as tuition bills start rolling in.

Related: Money 50: Best mutual funds and ETFs

The following strategies should help ensure you graduate at the top of the 529 investing class.

Leverage tax breaks to boost your returns

No matter which 529 plan you opt for, you will enjoy the same federal tax benefits on your savings: As long as you use the money for college expenses (tuition, room, board, and fees), you won't pay taxes on your investment gains. For a family earning $150,000 a year, that effectively boosts your return by about two-thirds of a percentage point annually, according to Morningstar analyst Kailin Liu.

Is the cost of college crippling?

In addition, 34 states and the District of Columbia allow residents to claim a deduction or credit for all or a portion of their 529 contribution to offset some of their state income taxes, though typically only for investments in that state's plan. Morningstar estimates the average value of the state tax break is $87 for every $1,000 invested, equal to an extra 8.7 percentage points in return in the year you make the contribution.

Over the short term at least, that more than makes up for any subpar funds your state 529 offers. Liu's research shows that the performance of the bottom 10% of age-based 529s have lagged the top 10% by up to five percentage points annually over the past three years.

Best strategy: First determine whether state tax benefits should even factor into your decision. Live in one of the nine states that don't levy an income tax or the seven that don't offer a 529 deduction? Then you're free to choose the best plan, no matter what state sponsors it -- preferably one that combines low costs with superior fund choices.

Likewise, if you live in one of the six, including Missouri and Pennsylvania, that let you deduct contributions to any state's plan. Find out the tax treatment in your locale and other plan details at savingforcollege.com by clicking the "select state" button.

Related: Another option for college savers

For parents in one of the remaining 29 states that offer families a write-off (or, in the case of New Jersey, a scholarship) only for investments in the home plan, you're often better off staying in state, says Hurley. That's especially true if the tax break is generous or you're investing for a teen, since it takes several years for superior performance to offset the initial tax savings.

One exception: Families who are frontloading investments for younger children and whose home-state plan has comparatively high-cost funds -- one with expenses greater than 0.5% of assets -- could benefit from starting off in-state, then rolling over the balance to a better out-of-state plan after a couple of years, Hurley says.

Some 14 states allow such rollovers without penalty. "It's a pretty good idea for a very young child," Hurley says, since you'll have many years for the better portfolio to pay off.

Consider how that strategy might pay off for a married couple earning $100,000 a year and living in the District of Columbia, where they can deduct contributions of up to $8,000 annually ($4,000 per person) to the local 529. If the couple invest the full amount in, say, D.C.'s age-based portfolio for newborns -- expense ratio: 1.35% -- they'll reduce their local tax bill by nearly $700.

Related: What is the best 529 plan for you?

To avoid repaying that tax break, D.C. requires the couple to keep the money in the plan for two years. At that point, the family could transfer those funds to, say, Utah's age-based plan for young children, which charges an expense ratio of just 0.2%.

While the initial impact on returns is small, the savings build up over time. After nine years, that extra 1.1 percentage points would translate into an extra $1,000 gain on the original $8,000. Assuming you contribute every year, you'd want to keep repeating the strategy until your child is within a year or two of college.

Be a bargain shopper

Higher fees than comparable investments outside of college savings accounts have been a big problem in many plans for years, and are a key reason why 529s have lagged in performance for most of the past decade. That's why it's especially welcome news that many sponsors have been lowering their expenses lately.

Strategic Insight, a fund research firm, reports the average fee for 529 funds dropped from 0.84% to 0.72% of assets managed in the three years ended Sept. 30, and many plans now offer one or more options below 0.5%. The leader in this largesse is South Carolina, which eliminated program-management fees and dropped its investment expenses for in-state residents to an average 0.13% last year, from 0.49% in 2011. California, Michigan, and Wisconsin also have aggressively cut charges recently and are now giving perennial low-cost leaders Nevada, New York, Ohio, and Utah a run for the 529 money.

Best strategy: Don't rely only on the generosity of plan sponsors to keep costs in check. Bypass a broker or other adviser and instead go to the provider's website to enroll directly, suggests Eric Nelson, a chartered financial analyst in Oklahoma City. (Find links to all programs at collegesavings.org.)

According to data from the College Savings Plan Network, a clearing-house for information about 529s, the average fee for an age-based portfolio sold directly is 0.54%, or two-tenths of a point lower than the industry norm, and 11 states keep those expenses below 0.3%. When you tack on the commissions and extra fees that pros charge to buy through them, adviser-sold plans typically nick your results by a full percentage point more than direct plans every year, says Nelson.

Related: Save for retirement or pay for your kid's college?

Within plans, there can also be a wide range of fees, so favor the lowest-cost option in keeping with the allocation you want, suggests Lisa Hay, a certified public accountant in Stow, Ohio. Usually that means sticking with passively managed index funds instead of actively managed portfolios.

Take the easy way (but not too easy)

Most 529 plans offer investors a choice between individual stock and fixed-income funds that you can use to create a customized college portfolio, or so-called age-based funds, which are similar to target-date funds for retirement. The plan puts together a stock and bond mix that's appropriate for a child depending on how old he or she is, then gradually shifts to a more conservative balance as the student gets closer to college.

More than 60% of parents choose the age-based portfolios, allowing the sponsor to make allocation decisions for them. That's certainly the easiest path, and often the smartest. But you can't simply trust that the provider knows the best mix for your child.

Allocations for kids the same age can vary dramatically from program to program and even within the same 529 if the sponsor is one of the many with conservative, moderate, and aggressive age-based tracks. For instance, the typical aggressive portfolio for 7- to 12-year-olds has about 70% in stocks, vs. 52% for the moderate option and less than 30% for the conservative track. "It is kind of shocking how different they are," says David Blanchett, head of retirement research for Morningstar Investment Management, who is helping to create indexes for age-based 529s.

Best strategy: Check the allocation of any age-based fund you're considering at the plan's website or Morningstar.com's 529 Center.

No matter how the age-based track is labeled, Morningstar recommends that the average investor with a moderate appetite for risk follow these basic guidelines for how assets should be split: Keep money for children younger than 7 almost entirely in equities -- at least 80%. Dial back stocks to 45% to 55% by age 12, and to about 10% by the time your child is within a year or two of college. Also look to see if the fund has international investments -- ideally about 15% of the stock portion of the portfolio should be in non-U.S. assets, says Blanchett. Some age-based funds invest only in U.S. securities.

Your allocation and risk-level choice should also be guided in part by how much you can invest and whether you expect your child to attend a public or private college. After running thousands of simulations, Vanguard, a major 529 provider, found that no matter how conservative or aggressive a fund they choose, families who are able to sock away $6,000 a year in an age-based portfolio starting when the child is a baby would have a 99% likelihood of banking enough to pay all four years of tuition, fees, room, and board for one student at an instate public college.

Related: College 101 -- How to pay for college

Accumulating enough for a private school is another matter. Putting that same $6,000 into a conservative fund that started out with a 50% stake in stocks and quickly tapered to all bonds by age 10 would give a family only a 53% chance of meeting average private college costs. An aggressive fund starting out 100% in equities and keeping at least 20% in stocks through age 17, however, would produce an 89% chance -- although if you do end up short of the target, you'd be more likely to miss by a greater amount.

Federal guidelines allow you to switch 529 investments once a year. So if the allocations in your 529's aggressive portfolio work best when your child is young, but the moderate mix is more suitable when your child is older, shift to the less risky track when your child hits his teens.

Favor vanilla over tutti-frutti

Since the financial crisis, states have made significant strides in improving 529 investment menus, adding safer insured accounts and specialized funds that allow families who want to pick their own mix to design a more diversified portfolio. Parents overall have 27% more investing options than in 2009, according to AKF Consulting, which advises states on how to design their 529 offerings. More than 40 plans, for example, now offer real estate funds; four provide commodities funds; and 13 have a wide array of exchange-traded funds, from small-cap to international portfolios.

Related: What's the best way for you to save for college?

Several plans, including Virginia's, even include a socially conscious fund that screens stocks based on the companies' respect for the environment and treatment of their employees. In addition, savers in at least six states can now choose to invest directly and fee-free in well-regarded funds managed by Dimensional Fund Advisors, which are usually available in nonretirement accounts only through advisers who tend to cater to wealthy investors.

Best strategy: It can pay to take advantage of the do-it-yourself options if you are saving for several children, have unusual circumstances such as very low or high total savings, or if you just don't like the prefab age-based offerings in your 529 plan. Of course, the DIY approach requires that you have the time and energy to ride herd on your investments.

As with the best prefab funds, start with a base of globally diversified low-cost indexed equity funds for youngsters. Then, add funds that provide either the safety or added growth potential you're looking for.

Protect your near-college kids

Shifting most of a portfolio into bonds and cash to safeguard principal as a child gets closer to college is standard practice. Yet parents of teenagers face a unique challenge now, since today's near-rock-bottom interest rates have nowhere to go but up, which in turn suggests bond prices are ripe for a fall. The risk is particularly acute for bonds with longer duration, a measure of the security's sensitivity to interest rate movements. The longer the duration, the more the bond's value will fall when rates rise.

Nevertheless, many 529 plans are shifting older kids' balances into bond funds with durations of up to six years -- which translates to a drop in value of up to 6% for every percentage point rise in rates.

Steve Dombrower, director of Oppenheimer Funds' College Savings Programs, says interest rate risk "is my biggest fear" for older kids. While actively managed Oppenheimer is buying shorter-term bonds to protect its funds for older children, plans using broad bond market index funds cannot make such adjustments. Some parents have had a taste of the danger. Nevada's highly regarded Vanguard-run "moderate" age-based plan for students already in college is down almost 3% this year because of its bond losses.

Best strategy: Check your fund's bond duration by clicking the "bond style" tab on your fund's options page at Morningstar.com. To estimate a portfolio's vulnerability to a percentage point rise in rates, multiply the duration times the percentage of the portfolio in bonds.

Don't like the result? Use your one annual portfolio move to switch into a more conservative option in your state or, if there are no tax costs, out of state. Blanchett suggests one of the TIAA-CREF Principal Plus Interest options available in 11 states, which insure the principal and pay between 1% and 1.5%. Alternatively, Savingforcollege.com gives its highest rating to Colorado's Stable Value Fund, in which MetLife insures the principal, and accounts earned 3% this year.

Three percent returns in a year when in-state public-school tuition rose only 2.9%? That would mean for the first time in decades, you could invest conservatively and still keep up with tuition prices -- a winning combo for college-bound families. To top of page

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Best in class
The 529 plans below offer college investors the best combination of low costs, well-designed investment portfolios, and high grades from the rating companies, Savingforcollege.com, and Morningstar.com.
Plan name Stock allocation (ages 0-6) 1-year return (ages 7-12) 5-year avg. annual gain (ages 7-12) Expense ratio (ages 13-18) Loss if rates rise 1 pct. pt. (ages 19+) Comments
Utah Educational Savings Plan 80% 16.9% 12.6% 0.22% -0.9% Of Vanguard plans, best combo of low-cost age-based and DIY options; like Nevada and Ohio, but more stocks early, less bond risk
Maryland College Investment Plan 96% 15.5% 15.1% 0.85% -1.5% Best actively managed 529, run by T. Rowe Price; similar to Alaska, but age-based portfolios for older kids face less bond risk
West Virginia Smart Select 88% 18.6% 12.7% 0.73% -1.4% Best choice if you want an age-based option using DFA funds
California Scholarshare 82% 11.9% N/A 0.27% -1.9% Low-cost provider of both passive and active funds, managed by TIAA-CREF
NOTES: Data are for moderate age-based portfolios; performance figures are through Nov. 30, 2013. SOURCE Morningstar
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