The college hunt is a parade of choices. Private or public. In-state or out-of-state. On-campus or off-campus housing. But when it comes to saving for school expenses, one choice is a clear winner -- a 529 savings plan.
Taking advantage of one of these state-sponsored plans is a no-brainer. A 529 plan shields your investments from federal income taxes, gives grandparents an easy way to boost their grandkids' college fund, and barely dents your chances for financial aid. And more than half the states sweeten the deal with a state income-tax deduction or credit. Investors have flocked to 529 savings plans. Assets grew from $11 billion in 2002 to $119 billion in 2009, and the average account balance is $12,000 -- about one year's tuition at a public university.
Take the tax break
You don't have to invest in your state's plan, but if your state gives you a tax break, it's often best to stay close to home. Thirty-four states plus the District of Columbia offer state income-tax benefits for 529-plan contributions. Five states provide a tax benefit regardless of which state's 529 plan you pick. Alabama uses a stick rather than a carrot: It doesn't tax distributions from its own plan, but it levies a tax on distributions taken from other states' plans. See our picks, state by state.
With any 529 plan, your savings grow free of federal income tax. Distributions escape federal income tax altogether if you use the money to pay for qualified educational expenses -- mainly tuition, fees, books, and room and board (you can use 529 money in 2010 to pay for a computer, but that perk is set to expire at the end of the year).
The accounts are flexible. If Junior doesn't want to go to college, you can transfer the funds to another family member and preserve the tax benefits. Or you can withdraw the money and pay income tax and a 10% penalty on the earnings. Unlike other education-savings programs, 529 plans allow families to participate regardless of income, and the states set a high ceiling on contributions (usually up to $300,000 per account).
Don't worry that a 529 will cripple your chances for financial aid. The federal financial-aid formula counts 5.6% of parent-owned accounts as part of the expected contribution to college costs -- a relatively painless hit compared with the 20% assessment on student savings.
Go the direct route
You can buy a 529 plan directly from each state or through an adviser. We prefer direct-sold plans because they don't charge commissions or adviser fees like adviser-sold plans do. You'll have to pay administration and investment-management fees with any 529 plan, however. Most states offer several investment tracks, which range from conservative to aggressive. More than 60% of investors put their 529 money on autopilot by choosing age-based portfolios, which automatically shift from stock funds to bond funds and cash as the student approaches college age.
Picking a plan is a bit more complicated if you live in a state that doesn't offer a 529 tax break. Depending on what you're looking for, go with one of five plans that rise to the top of our list:
Low fees. We like the index portfolios in the Illinois direct-sold Bright Start College Savings Plan. The portfolios, which include mostly Vanguard funds, charge rock-bottom fees, which range from 0.20% to 0.22%.
Ready-made portfolios. Ohio's CollegeAdvantage 529 plan offers great choices from Vanguard, Pimco and GE Asset Management, as well as certificates of deposit from Fifth Third Bank.
Low risk. Savers who shy away from stocks should check out the Michigan Education Savings Program. It has an option that guarantees principal and doesn't charge an annual fee.
Varied menu. Fund pickers can benefit from the direct-sold College Savings Plan of Nebraska, with its selection of 20 funds from American Century, Fidelity, Pimco and Vanguard. The wide assortment does come with higher fees; the most expensive fund option costs 1.64% annually.
Adviser-sold fund. If you feel more comfortable going this route, the Virginia CollegeAmerica plan is a standout among adviser-sold 529s.
The plans do have a number of drawbacks, but there are ways around them. You can change your 529 investment choices only once a year, which can hurt (or help) if you're tempted to tinker. One alternative is to go with a set-it-and-forget-it option, which does the tinkering for you.
Like just about every other investment, 529 plans took a big hit during the recent bear market because they turned out to be riskier than expected. As a result, a number of states, such as Colorado, Kansas, Utah and Wisconsin, have added bank CDs, FDIC-insured savings accounts, U.S. Treasuries and money-market funds to their investment lineups.
As for fees, expect them to fall as assets grow and managers vie to attract more customers. Last December, Fidelity cut management fees in half for its index portfolios and by one-third for its actively managed portfolios for five direct-sold 529 plans it runs. The Utah Educational Savings Plan, one of the lowest-cost 529 plans, reduced fees on some investment options in February.