Where to stash college savings

By Morningstar

With so-called 529 college-savings plans, there's an advantage to staying close to home: States often offer tax deductions to residents who contribute to their own state's plan.

That's an argument in favor of sticking with your state's plan, to be sure, but the value of the tax incentive may be far outweighed by other factors. After taking other plan features into account, you might find it pays to invest out of state. Here's what college savers should look for when determining whether to stay in state or search for greener pastures elsewhere.

Pinch pennies

As dull as it sounds, expenses matter. When it comes to funds, Morningstar research has shown that expenses are the best predictors of long-term returns, so the cheaper the fund, the better the chance it will outperform. This makes intuitive sense. There's no guarantee that the market will favor a fund's strategy or that the manager will make the right calls, but how much you pay will be a sure thing.

Fees are even more important in the 529 world. Along with the underlying fund expenses, you face additional administrative and management fees tacked on by 529 plans, not to mention the commissions you'll pay if you invest through a broker. After adding it all up, investors can lose quite a bit of their returns to expenses.

Stocks, bonds and everything in between

The structure of your portfolio is also something to carefully consider, particularly because many studies demonstrate that asset allocation is one of the primary drivers of returns. Of course, some investors can handle more volatility than others, so there's no one-size-fits-all solution, but there are some rules of thumb:

Diversification matters. Some plans offer little in the way of international or small-cap exposure. That limits your potential return and makes your portfolio too reliant on domestic large caps.

To see how your state's plan stacks up in the asset-allocation department, take a look at this article (registration required) by Morningstar's David Kathman. He uses target-date retirement funds to offer some guide as to the right mix among asset classes.

Your time horizon is another important consideration. The more time you have before your beneficiary reaches college age, the more you can handle the fits and starts that come from aggressive asset classes. In that case, it makes sense to stick mostly to the more volatile, but higher-returning, equity market early on.

Conversely, if you have only a few years to save until college, your portfolio may not have time to recover from a painful drop in the market like the one investors have recently experienced. Thus, sticking more assets in bonds is typically more sensible because bonds tend to offer a steadier ride than stocks. It's straightforward enough, but not every state offers reasonable transitions between stocks and bonds.

Continued: The bread and butter

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