Best 529 Plans: Everything You Need to Know

by Darwin on May 11, 2010

If you have children, or are even thinking of having kids in the future, you’ve probably heard about 529 college savings plans and may be participating in one already. While the premise is pretty straightforward, there are some provision, benefits and tips that ensure you set yourself and your progeny up for success in establishing the right plan and approaching 529 investments the right way.

529 Basics

First things first – there are two types of 529 plans:

  • Pre-paid 529 plan – in the pre-paid option, you basically insure against future inflation and market volatility by buying college credits at today’s prices for use later. Based on the recent tuition inflation we’ve seen, many parents are perfectly comfortable just buying credits at today’s prices and not having to worry about say, tuition increasing at 10% per year while the stock market’s flat for another decade. Or perhaps you’re spooked by the recent financial meltdown are don’t consider yourself to be a savvy investor, even with broad asset allocation selections offered within plans. This may be the way to go.
  • Savings Plan – in the savings plan, the 529 account is treated virtually the same as any other investment account like what you might have at work in a 401(k) or 403(b), or even an IRA account. Each state offers their own investment options and you must abide by those options. While this may seem a bit more complex than the pre-paid option, you full control over the investment allocation and if you consider the prior decade an anomaly from both an investment and tuition inflation standpoint, by historical standards, you would fare much better investing in stocks early on and realizing a high single digit annualized gain for over a decade as opposed to buying credits at today’s prices. That assumes that stocks outpace tuition inflation of course. In the savings plan, investment gains continue to grow untaxed in the account unless you take an early withdrawal for some reason, at which point there is a 10% federal tax penalty as well as a payback for state tax deductions (more on that below).

What Expenses Can be Drawn from the 529 Plan?

Basically, virtually all higher education costs can be justified – from tuition and books to room and board.

  • You Control the Money – If you’re worried about little Johnny going out and buying a sports car with the funds when he gets his license, you can rest assured that as the account owner, you control the funds disbursement. There’s pretty impressive flexibility in this regard, where you can transfer funds to another sibling or even withdraw the money yourself with said penalty.

What is the Best 529 State Plan?

This is a difficult question but I’m not going to cop out completely. Here’s my take. First of all, rules vary by state and you need to first research your “from” and “to” state thoroughly. For instance, some states allow you to deduct state taxes from any 529 investments up to a set limit. In some cases, you have to invest in your own state’s plan, whereas in others, you can invest in any state.

Which 529 Plan Did I Choose?

Personally, I live in a state where I can deduct 529 contributions from my tax liabilities each year even if I invest in a 529 plan from another state. As such, I obviously chose the flexibility of going out of state and researched several plans thoroughly. While I found a few plans to be compelling, I went with with Iowa 529 Plan.

Why Iowa? In considering the various options at my disposal, since so many plans were offering similar provisions, I focused on two key aspects – flexibility in investment choices and low fees. Given the extensive time horizon, by focusing on the lowest fees possible and the most aggressive investments possible, I feel I can optimize the long-term return. You get what you pay for on the risk/return continuum. If you want to lose money to inflation (even more so with tuition inflation), you can invest in money markets and government bonds at today’s levels. Conversely, if you can stomach some wild volatility, over long periods of time, stocks have always exceeded the returns of all other conventional asset classes.

Within the Iowa plan, they partner with Vanguard, who I view as the most ethical, competent, low-cost solution in indexing, ETFs and mutual funds (yes, I’m a boglehead). The total plan expense ratio is 0.5% (they lowered it again! in Oct2010) 0.34% which was lower than what many of the other plans required. Additionally, the most aggressive investment option was comprised of the following investment allocations:

  • 60—72% Vanguard Institutional Index Fund
  • 8—20% Vanguard Extended Market Index Fund Institutional Shares
  • 20% Vanguard Developed Markets Index Fund

For the most part, this portfolio will greatly mimic the return of the S&P500 and other US stocks not included in that largest US benchmark index, as well as provide exposure to Europe and the Pacific rim through the combination of these funds.

Consider Your Real 529 Plan Returns

When selecting a plan, you may be confronted with the option of only deducting state taxes by investing in your state’s plan while not being lit up over your state’s investment options. In this case, it’s still probably likely that the state tax deduction will outweigh the added benefit of better options in another state. In my case, I’m getting an added return of over 3% over benchmark each year due to my tax deduction with the added bonus be being able to pick a low-fee plan in another state. So, the Iowa 529 plan may not be for you, but at least it gives you some food for thought.
You can also give your returns an added boost with effortless free funding out of a Upromise Account. I’ve been using an account for years and have accumulated a few hundred dollars with no effort. Essentially, you add your store loyalty cards like CVS cards and grocery store cards, as well as credit card accounts to the UPromise account and then you get paid typically from 1% to 10% for various purchases in exchange for your loyalty to those brands. Once the account is established and accounts linked, you can set it and forget it. Some of the larger participants in the program that pay back consumers include: Wegman’s, Giant, Exxon and online shopping at stores like Gap, Home Depot and more.

A further consideration is that 529 account assets are typically considered in financial assistance calculations so if you were on the fringe for some sort of assistance, these assets may impact that outcome. However, banking on assistance and NOT saving for college in the hopes that the money will be there someday doesn’t seem like a sound strategy to me.

Which 529 Plan Are You Using and Why?

{ 4 comments… read them below or add one }

Hope to Prosper May 20, 2010 at 1:23 pm

This was an informative and well-written post.

When I started my kids college funds, 529 plans weren’t yet available. So, I used UGTMA (Universal Gift To Minors) accounts. I was curious what the exit liabilities if a 529 plan was, because one of my kids dropped out of high school as a senior. But, now he is attending a community college.

Thanks for all of the information.

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Darwin October 17, 2010 at 5:56 pm

True, when I first started saving for college, I chose an ESA over 529 since the fees were higher. It had a $2000 cap though. Now, 529 has lower fees and much higher cap, seems like the way to go.

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kevin cimring October 10, 2010 at 12:59 am

Thanks for the very useful post. I am setting up 529’s at the moment, so this came in very handy. I am looking at the Iowa plan or the Vanguard Nevada plan. Both are, in essence, Vanguard funds at the core with relatively cheap expense ratios. Both look pretty good.
Regards
Kevin

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Darwin October 17, 2010 at 5:57 pm

Can’t go wrong with Vanguard. Glad to see most of these plans are focusing on getting costs down over time. Pleasantly surprised to get a notice today that the expense ratio just dropped even further, from 0.5% to 0.34%.

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