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The Basics

Where to stash college savings

The tax incentives of an in-state 529 plan are obvious, but the benefits may not be as great as they seem. Here's how to tell whether you'd be better off investing out of state.

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.

Consider, for example, the Nebraska AIM College Savings Growth Allocation Fund 529 Portfolio. Investors pay 1.61% in total annual asset-based fees, along with a sales charge of up to 5.5% and a $25 annual account fee.

College savers invested in a similar growth-focused portfolio through Virginia's CollegeAmerica 529 plan would also pay a sales charge but just a $10 annual account fee and 0.8% in annual asset-based fees. That gives investors in the Virginia plan a big head start, and the money saved from lower expenses will compound over time.

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, including the Florida College Investment Plan, 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 my colleague David Kathman. He uses target-date retirement funds to offer some guide as to the right mix between asset classes.

Video on MSN Money

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All about 529 plans
These state-sponsored college savings plans are becoming increasingly popular. Here's why.

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. 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.

Wisconsin's EdVest plan is one culprit with an abrupt shift between the two. Because that plan is the better of Wisconsin's 529 plans, Badger State residents might want to check out what's available elsewhere.

Continued: The bread and butter

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