Section 529 Plans: Finding the Best Plan for You

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If you decide that a Section 529 plan makes sense for you and your family, the next step is putting theory into action and actually opening and funding a Section 529 plan. In this article, you figure out how to choose the plan that's right for your situation (every plan fits someone's life, but not every plan may be right for you) and how to fund it.

When you're looking at most things, the cookie cutter approach almost never works, and that is especially true of financial planning and college savings. No two families are exactly alike, and what works best for your siblings and your friends and their families probably won't be what works best for you and yours. You can make your Section 529 plan(s) a success for your family, but first you need to consider exactly what your needs are.

Creating a 529 Checklist

Just like shopping for groceries, clothes, or a house, you'll be most efficient in choosing a plan when you know exactly what you need before you ever look at what's being offered. Plans that have features you don't need but lack qualities that you do may work well for some people, but not for you.

Here is a checklist that you should have answers to before you start looking. Keep in mind that your answers today don't necessarily need to be your answers tomorrow; these plans are flexible and can be changed as needed.

• Who will be your designated beneficiary? Your plan choice may vary depending on the age of your student. You may also choose differently for your child who has a lifelong membership in the Future Doctors of America than for your child who lives with his head in a car engine.
• Where does he or she anticipate attending school? If your designated beneficiary is an infant or young child, she obviously can't express her college preferences — even if you have taught her every word of your alma mater's fight song. But don't despair — this is where your expectations come into play. You choose; you can always change it later.
• What do you anticipate the cost will be of that choice at the time your student will be attending, not only for tuition but also for all other expenses? Now it's time for you to do some homework, checking out all the expensesand figuring out where your child's choice slots into that equation.
• Given your current income and future earning potential, is your student likely to qualify for need-based financial aid when the time comes? If there's no way that you'll ever be able to pay the full amount, looking at how different types of plans are counted in the federal financial aid formula may make one plan preferable to another.
• What state do you live in, and does your state give tax benefits either for contributions to its own Section 529 plans or for distributions from its own plans? Does it give tax benefits to contributions and/or distributions from other states' Section 529 plans?
• How much can you reasonably put away into a 529 plan on a regular basis, without unduly strangling your family budget and dooming you to a life of beans on toast? You want to save as much as you reasonably can, with the emphasis here on "reasonably." You still have to live now. If you're happiest when you're squeezing the buffalo on a nickel so hard you can hear it squeal, go for it. But if life without the prospect of an occasional movie or dinner in a nice restaurant (fast food doesn't count here) seems like an endless, dark existence, you may want to save a little less and budget a set amount for current little extras.
• Who's your successor-designated beneficiary, and who's your successor owner? And will your successor beneficiary and owner meet residency restrictions your plan may have?

With completed checklist in hand, you can select a plan and begin saving.

If your and your student expect that he or she will attend either a state college or university or a community college, the first place to look is at prepaid tuition options in your own state or the state in which your student plans to attend school. But, if you see only private options, out-of-state public universities, or a graduate/professional school career in the future, you may want to look only at savings plans run by the mutual fund companies.

Looking at State-Run Plans

At the time of this writing, 529 plans include thirteen state-run prepaid tuition plans, five guaranteed savings plans (two of which are also prepaid tuition plans), and one plan that isn't qualified under Section 529 (Massachusetts U.Plan) but which really falls within all the other parameters and has many of the same tax advantages of state-run 529 plans. Of these plans, only Alabama and Massachusetts have prepaid tuition plans open to all, and Colorado is the only state that opens its guaranteed savings plan to everyone; all other state-run plans are restricted to resident donors, resident beneficiaries, or both.

Read the fine print carefully; plans may have restrictions beyond residency. Many limit the age at which you can set up a plan for a specific beneficiary, so you may be out of luck in a particular plan if your student is in high school already and you haven't yet begun. They may also restrict when distributions must start and when you must complete your distribution schedule.

Rates of return on prepaid tuition plans haven't kept pace with annual tuition hikes, and many prepaid tuition plans are running huge deficits and teetering on the edge of insolvency. States are dealing with this in one of three ways:

• Charging increasingly large premiums for each tuition contract or unit you buy: For example, you may have to pay 150 percent of the current cost of one year's tuition to buy one year of future tuition.
• Decreasing the amount of tuition you thought you bought: For example, you may think that you bought four years but may receive only three.
• Closing the plan to new enrollments: West Virginia, for example, closed new enrollments in its plan due to a $16 million deficit. The state has said that it intends to honor all contracts that have been purchased.

Most plans are backed by the full faith and credit of the state (which means they'll cover any losses, so you're not at risk) or by contingencies written into the statutes governing their plans that require action by state legislatures, the governor, or some other stopgap to plug the holes. But not all plans have backup plans in place. Once again, you need to read the fine print carefully.

Table 6-1 lists the prepaid tuition and guaranteed savings plans currently available. This is only a place to start. Plans can be added and dropped, and new enrollments and/or new contributions can be suspended at any time. Check with your state, or the state whose plan you're considering, for up-to-date information when you're ready to enroll your student.

Table 6-1:  Prepaid Tuition (PT) and Guaranteed Savings (GS) Plans, by State

In addition to prepaid tuition and guaranteed savings plans, some states also offer savings plans that they administer themselves. Most of these state-administered savings plans limit their investments to fixed income securities (bonds). And, because states aren't in the business of making money off your investments (other than by taxing the money that you do make), the fees associated with these plans tend to be very small. Investing in a state-run savings plan is fairly low risk but also provides a fairly small return on your investment. If you feel that you'd like to be a bit more daring with 529 funds (and you need to see at least the possibility of big gains in their value), you'll probably need to invest in plans administered by the mutual fund companies.

Finally, if you like the idea (and relative safety) of prepaid tuition plans but don't see your child attending a public university or don't live in a state that offers a plan, you may want to consider investing in an institutional prepaid tuition plan.

Considering Mutual Fund Plans

Most prepaid tuition plans only cover tuition (and mandatory fees). But higher educational costs only begin with tuition. All the other college costs need to be paid for, too. Whether you go the prepaid tuition route or want more choice in investments and schools where you can use that money, you may want to explore the Section 529 savings plans. These savings plans are established by the states, which then contract with mutual fund companies, companies whose sole business is putting money to work to make more money. And this is how these companies market themselves: They hold up their expertise and flexibility (as opposed to some employee at the state treasurer's office who can buy only certain sorts of bonds) and lure you in with pictures of past performance dancing in your head.

The truth is that mutual fund managers are pros, and if there is a way to make money in the stock and bond markets, they're very likely the ones who will figure it out. They are not, however, infallible, and many a fund has plunged in value even as the general markets have risen or stayed the same. Those past performance numbers show only how the fund has done in the past — they don't predict how any fund will perform in the future.

No matter how well, or poorly, a particular manager has done, the fact remains that if you want to invest in a Section 529 savings plan, you're almost definitely going to have to deal with the decisions of at least one mutual fund manager over the lifetime of the account because the vast majority of states farm out their investing to these companies.

Before you jump right in to a professionally managed savings account, you need to remember a few things:

• Professional money managers don't work for free, nor are they cheap. Management fees associated with Section 529 savings plans that are managed by mutual fund companies are notably higher than fees charged by state-managed plans. Fees widely vary; check carefully and be prepared to pay even when your account isn't gaining in value. The fund companies don't drop their fees out of the goodness of their hearts.
• Many mutual fund plans can't be purchased except through a broker or a financial planner. If the fund that you want can be accessed only in this way, you need to know that you're going to spend a substantial amount in order to join. Not only will you have the fund fees, but you'll also be paying a broker's commission. As you flip through the appendix in the back of the book, any fund that states it's sold only through a financial advisor has this extra fee tacked on.
• Mutual fund companies make money on large accounts, not small. Although the amount required to start in any fund varies not only by state but also by mutual fund company, many companies require a substantial initial investment. You may find that you need to have between $1,000 and $3,000 just to open an account. Carefully check the plans you're interested in for minimum opening deposit amounts.
• Just because a professional is managing your money doesn't mean that you can just sit back and relax. You are ultimately responsible for the well-being of your 529 account, and you need to be ready to make changes when whatever the plan manager is doing is clearly not working.

Most mutual-fund managed plans, while authorized  by a specific state, aren't restricted in any way to only state-resident owners or beneficiaries (Kentucky, Louisiana, and New Jersey are the only exceptions at the time of publication). This lack of restrictions allows you a great deal of latitude when shopping for a plan, especially as more states rework their tax laws to allow tax-exempt distributions from out-of-state plans (most plans don't tax the income portion of qualified distributions from their own plans owned by in-state residents). You need to be careful, though, and make sure that your state not only currently follows these rules but continues to follow these rules. As states struggle to close budget gaps, the untaxed money from 529 distributions may be attractive additional sources of income. If your state changes the rules regarding income taxation of out-of-state plan distributions, you may want to relocate your plan to your home state.