Congress 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 roughly 50 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. 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. Still, a 5%-9% tax deduction on every dollar you contribute ought to get your attention, and should probably earn your business unless you specifically dislike the plan's allocations, funds, or fees. Check SavingForCollege.com for a quick overview of your plan as well as ratings of all the 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. Naturally, 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, and make a big difference over many years.
• Prefer plans with low-cost index fund choices. As most SMI readers know, 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. However, in a 529 plan, you don't have the flexibility to Upgrade like that. Given that lack of flexibility, the next best thing 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 that your state will offer index funds among their investment options. Here are a few plans to check out as a basis of comparison (fund choices are constantly changing, so this is unlikely to be a comprehensive list): Utah, New York, Iowa, Nevada, and Nebraska. If you find more than one plan with similar index choices available, look closely at your total cost of investing in each plan.
ConclusionTo summarize then, if you qualify for a Coverdell ESA and are inclined to follow SMI's Upgrading strategy (or another strategy designed to beat the market's rate of return), your first college savings dollars should be directed there, up to the maximum $2,000 contribution each year. Any excess savings beyond that can be directed to a 529 plan. If, on the other hand, you either don't qualify to contribute to a Coverdell, or plan to use an indexing strategy anyway, find a 529 plan with solid index fund choices and focus your savings there.
