Choosing a 529 Plan

A recent survey showed that while almost two-thirds of parents were saving for college, only about one-third are saving in a 529 plan. That’s unfortunate, since 529s are usually the best choice for savings, for a lot of reasons. On the other hand, it’s not unexpected, given that the vast array of often confusing choices can be a barrier to use. So, how do you choose?

Let’s start with a few basics. Your 529 choice has no– zero, zip, NADA– impact on your college choices. Any 529 can be used at any college at which you could take out a federal student loan. This includes not just four year colleges but community colleges, trade schools, and even some international universities. All 529s are treated as parent assets on the FAFSA– the same as a taxable account or a savings account. Each 529 account has an owner (usually the parent) and a beneficiary (the student). All 529s offer tax-free growth and distributions for qualified higher education expenses: tuition and fees, book, supplies including a computer and Internet access, and room and board– on-campus or off-campus.

Here are a few questions to ask to get yourself pointed in the right direction.

Does your state offer a tax benefit?

If so, then you’re almost always better off using your state’s plan. (Check here if you’re not sure.) There are a few exceptions: a few states– currently Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania– allow you to take a state tax deduction for a contribution to any state’s plan. Generally speaking, though, state tax benefits go hand-in-hand with other good plan attributes like low plan fees, progressive age-based portfolios, and small minimum investments.

If not, look to a low-cost plan like Utah’s my529 or a non-state-based plan like the Vanguard 529 plan.

How much are you going to contribute?

If you’re not going to contribute a lot, use a state plan. State plans typically have very low minimum contributions– as low as $5. Non-state-based plans like Vanguard’s have higher minimums: Vanguard’s minimum initial investment is $3,000; the minimum ongoing contribution is $50.

Are you planning to use your 529 for K-12 expenses?

Not all states conform to the TCJA change allowing $10,000 of K-12 tuition expenses to be paid from a 529. Before deciding whether to use a 529 for K-12, you should determine if you live in a nonconforming state and whether the state imposes additional penalties on nonqualified distributions. If your state is nonconforming but doesn’t impose additional penalties, use an out-of-state plan for K-12 expenses. That way you won’t be subject to state tax deduction clawbacks which, even if they’re not large, are a headache. If your state has additional penalties, you probably don’t want to use a 529.

By now, 97% of readers should know everything they need to choose a plan and get started. To recap: If your state offers a tax benefit and you’re only using the account for college, use your state’s plan. If you don’t get a tax benefit, you don’t have to use your state’s plan to get a tax benefit, or you want to use your 529 for K-12 expenses but your state doesn’t allow that, use Utah if you’re contributing less than $3,000 or Vanguard if you’re contributing more. If you have more questions, read on!

Should you use the plan your advisor is recommending instead of your state’s plan?

Many investment advisors offer to manage clients’ 529 assets, usually for a fee. Some use a custodian-based plan such as those offered by Schwab, Fidelity or TD Ameritrade. Others use advisor-sold state 529 plans. The big question is cost: Is your advisor charging a management fee to manage your 529? Or are they using the more expensive advisor-sold plan in your state’s plan? Fees charged against your account– whether management fees or higher expense ratios in mutual funds– result in lower investment returns over time and less money available for college. Unless you are somehow completely unable to manage setting up an account– completing the (online) paperwork, linking your bank account, deciding on a monthly contribution amount, and choosing an age-based investment portfolio*– you should avoid advisor-sold plans or having your advisor charge a management fee on your 529 assets. Furthermore, with the age-based portfolios available in direct-sold plans, you don’t need an investment advisor to choose an asset allocation for you.

Savings Plan or Prepaid Tuition Plan?

529s come in two types: savings plans and prepaid tuition plans. Savings plans are far more common. In a savings plan, you contribute money and choose an investment portfolio. Your money grows at the growth rate of the investment portfolio. If the investment portfolio gains 8% one year, your account balance will grow by 8%. If the portfolio loses 8%, your account balance will decrease by 8%. Prepaid tuition plans, on the other hand, let you buy “tomorrow’s tuition at today’s prices.” That means that whatever investment markets do, your account balance will grow at the same rate as tuition grows. For example, if one semester’s tuition is $5,000 when you make a contribution and you deposit $5,000, you have prepaid one semester of tuition, regardless of what tuition costs when you actually attend. There are a few other considerations with prepaid tuition plans:

• The tuition inflation rate used in these plans is tied to specific colleges and might be different if you go elsewhere. For example, the Private College 529 gives participants actual tuition inflation if they attend any of its 300 member schools. However, if you don’t attend a member school, you get a lower inflation rate.

• With few exceptions, prepaid tuition plans can only be used for tuition, not for room and board.

• Prepaid tuition plans typically require you to invest the funds for at least 3 years.

• Several states including Washington and Florida offer great prepaid tuition plans that can be used at any college; however, only residents of those states can participate.

I think a prepaid tuition plan can be a great complement to your regular 529 savings plan, especially as your student gets closer to college. In the current investment environment where low returns in fixed income prevent your age-based portfolio from keeping up with tuition inflation, having a guaranteed return somewhere in your portfolio can be beneficial. (Full disclosure: some of my daughter’s 529 money is in the Private College 529 since she attends one of their member schools.) However, for students further away from college, the investment returns that an age-based portfolio should earn are likely to be higher than what you will get in a prepaid plan. And of course if you want money for anything other than tuition, you’ll need a savings plan.

In summary:

• If your state offers a tax benefit, use your state’s plan. If it doesn’t, choose Utah’s my529 if you’re contributing less than $3,000 or Vanguard’s if you’re contributing more.

• If you want to use your 529 for K-12 expenses, check if your state allows that. If not, use Utah’s my529 or the Vanguard plan.

• Avoid advisor-sold plans or any plan where your advisor charges a management fee. 529s are very well suited to DIY saving and investing.

• A prepaid tuition plan can make sense as part of your overall savings mix, but it usually makes sense to wait to invest in these until your student is in high school.

And don’t wait to make this a new year’s resolution. Most states require your contributions to be made during the calendar year in order to claim a tax benefit, so waiting until January means leaving free money on the table.

* Choosing an age-based investment portfolio really only requires you to know how old your child is and match that to an investment choice.

See College Savings Options for more.