The Best Way to Save for College

Saving used to be so much simpler. No matter what particular goal you were saving for, you did the same thing: put money aside and figured out how to invest it.

Nowadays, you'll have to learn about special types of accounts designed for particular savings goals. Want to save for retirement? You'll need to decide whether a 401(k) or 403(b) plan from your employer beats out the benefits of a Roth or traditional IRA. And in the college savings realm, 529 plans are attractive, but choosing among your many plan options gets a lot trickier.

Alternatives to 529s
There are ways to save for college other than using 529 plans. Opening a custodial account for your child is easy, but many parents aren't comfortable with turning over the money to their children when they become adults. A Coverdell ESA has many of the same attributes as an IRA, but contributions are limited to $2,000 per child annually -- a pittance compared to the cost of a college education these days.

529 plans bring the best combination of desirable traits to help you save for college costs. Once you contribute to a 529 plan, the income grows on a tax-deferred basis. When the time comes, as long as you spend the money on qualified educational expenses, that income becomes tax-free. Contribution limits are huge, letting you contribute $200,000 or more in total for each child.

What to look for
The tricky part, however, is choosing from the dozens of 529 plans available. Every state in the union offers a 529 plan, and most of them are open to people from anywhere in the nation.

To find the best 529, here are some of the things you should look for:

  • Low fees. High-priced 529 plan options are sadly quite common, but there are enough alternatives so that you shouldn’t have to waste money on costly plans.
  • Flexible investment options. You'll want enough choices to put together a solid, diversified long-term portfolio.
  • Good performance. Saving for college doesn't give you much time to recover from mediocre or bad returns. Even if you start saving immediately after your child is born, you have less than 20 years for your money to grow enough to finance your child's education. Don't waste that time on subpar results.
  • Tax benefits. Many state 529 plans offer tax breaks to in-state residents, such as income tax deductions. It's always worth it to take a look at your own state's plan first, although you may end up deciding that it's not the best choice, even despite some tax advantages.

Let's take a look at a couple of different plans to get a feel for what's available.

Good, bad, or ugly
One 529 plan I like is Ohio's CollegeAdvantage Plan. It offers a range of different investments, ranging from age-based options that look a lot like target retirement funds for future college students to investments in various stock funds from Vanguard and other providers. Take a look at some of the choices:

Investment

Cost

1-Year Return

Holdings of Fund Include ...

Vanguard Windsor II

0.48%

(10.3%)

IBM (NYSE: IBM  ) , JPMorgan Chase (NYSE: JPM  ) , Microsoft (Nasdaq: MSFT  )

Vanguard Morgan Growth

0.48%

(10.1%)

Cisco Systems (Nasdaq: CSCO  ) , Apple (Nasdaq: AAPL  )

Vanguard Developed Markets Int'l Stock Index

0.28%

(6.9%)

BP (NYSE: BP  ) , Vodafone (NYSE: VOD  )

Source: College Advantage, Morningstar. Performance as of Aug. 31.

Notice that in the market's swoon over the past year, these funds lost a lot of money. But the plans' low costs have helped limit those losses and should continue to boost performance going forward.

On the other hand, many plans aren't as good. One of Montana's 529 plans, for instance, has seen many of its investment options lose 10% or more annually over the past three years. Moreover, some of its options had expenses of over 2% annually, and none had total expenses less than 1%.

Send yourself to investing school
A good 529 plan can help get your kids the education they deserve, but it might take some learning of your own to get the best deal. What you save with lower fees and better investment results, however, will make it well worth the extra effort.

No matter what you're investing for, you need to be smart about your portfolio. John Rosevear explains one tempting choice that could be the biggest mistake you ever make.

Fool contributor Dan Caplinger started saving for his daughter's education when she was 1. He doesn't own shares of the companies mentioned, although he does invest in Ohio's 529 plan. Apple is a Motley Fool Stock Advisor pick. Microsoft is a Motley Fool Inside Value selection. Vanguard Morgan Growth and Windsor II are Motley Fool Champion Funds recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you a great education about what we do.


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