So, while you forfeit the right to pick and choose the exact investments you want in a 529 plan, you can still exercise a significant amount of control over how the assets are invested by utilizing the ever-expanding array of choices within these plans. For example, the New York plan offers five different Vanguard stock index funds, plus a bond index fund, among its twelve individual portfolio choices. Account holders can own up to five of these options in one account and can specify what percentage they want allocated to each fund. When you consider that you can change investment options as often as once every twelve months within most plans, and can redirect new contributions at any time, you can see there's quite a bit of flexibility allowed. You also have the ability to roll your account from one state's plan to a different one with better investment choices. This can only be done once in any 12-month period, but aside from that it's a simple process.
Congress initially put the states in charge, and each one is doing its own thing—creating different rules for who can participate, how much can be put in, how the money will be invested, and so on. The fact that there are so many plans to choose from creates a lot of confusion for parents. Here, then, are my suggestions as to which factors are most important.
• Shop around, but check your own state's plan first. Look beyond your state's borders. Most plans offer state tax deductions for contributions made by their residents, and this often convinces parents to look no further. After all, a 5%-9% state tax deduction on every dollar you contribute ought to get your attention. But be aware that other factors, such as the quality of the investment managers, number and type of asset allocation choices, and the level of management fees, can outweigh the value of a state tax deduction. Check SavingForCollege.com for an overview of your plan as well as ratings of other plans open to non-residents.
• Look closely at your asset allocation options. Your most important decision is the allocation between stocks and bonds in the account. Many of the age-based portfolios are quite conservative, moving into bonds in large doses at an early age. At the opposite end of the risk spectrum, you can take a more aggressive posture by using the static portfolio options to stay 100% in stocks from birth to graduation. The right balance is somewhere between those extremes. While you don't want to be in bonds too early, it is appropriate for the allocation to get more conservative as college age approaches. This helps assure that the account won't suffer a significant loss just as your student enters college. Make sure the allocation options fit with your desires as to how aggressive you wish to be. One simple approach for those using static portfolios is to invest 100% in stocks until college is five years away, then shift 20% of the account into bonds each year until college arrives.
• Consider the fees. Just as with a mutual fund, there are ongoing operating expenses charged to your account. These fees can vary by more than 1% annually, making a big difference over many years.
• Favor plans with low-cost index fund choices. At Sound Mind Investing, we firmly believe that it's possible to beat the market's returns if you're able to rotate between top-performing funds as we do in our Fund Upgrading strategy. Helping our readers outperform the stock market for eight straight years speaks for itself. However, in a 529 plan, you don't have the flexibility to Upgrade like that. The next best thing, then, is to use index funds. Study after study has shown that index funds will typically beat the majority of actively-managed funds over time, in large part due to their lower expenses. As a result, our advice in picking a 529 plan is to find one with good index fund choices. More and more states are catching on to the virtues of having low-cost index funds in their plans, so it's increasingly likely your state will offer index funds among their investment options.
