The last thing do-it-yourself investors want is for someone to tell them what they have to invest in. Unfortunately, despite all the great tax advantages that 529 college savings plans offer, most of them severely limit the types of investments you can make. But one state's plan has pioneered the use of ETFs within a 529 plan framework, giving you a college savings option you can live with.

The pros and cons of 529s
 Last week, I talked about how 529 plans have a lot of advantages for college savers. They offer the ability for your investments to grow on a tax-deferred basis as your children grow up, letting you avoid having to pay taxes on income and capital gains along the way. And as long as you use the money for qualified college expenses, you'll escape tax entirely, as the income then becomes tax-free. In addition, you'll find some financial aid advantages that favor keeping money in a 529 plan as opposed to using alternatives like a custodial account.

The downside, though, is that each plan has a limited selection of investments. Just as most workers have to put up with specific menus of funds in their 401(k) plans, each state decides which investments they'll offer their plan participants. Even though cost is a major consideration in picking a 529 plan, you have to weigh those costs against how much flexibility a plan gives you to invest your money the way you want to.

Striking the right balance
If you want the flexibility that ETFs provide, the Arkansas iShares 529 Plan may be exactly what you're looking for. As you'd expect from the name, the Arkansas plan utilizes ETFs from BlackRock's (NYSE: BLK) iShares for its investment options. You can choose from among the following options:

  • Seven ready-made portfolios with asset allocations based on the year your child will enter college, ranging from now to 2027.
  • Four ready-made portfolios with asset allocations based on risk tolerance, ranging from aggressive to an ultra-conservative all fixed-income portfolio.
  • Nine single-ETF portfolios that you can mix and match to create your own portfolio.

That last option is exactly what do-it-yourself investors want, because it lets you build a unique asset allocation based on your own investment objectives and beliefs about the future. Here's more information about the ETFs offered:

ETF

Expense Ratio

1-Year Return

Index Tracked

iShares Russell 1000

0.50%

10.4%

 Large-cap U.S. stocks
iShares Russell 2000 (NYSE: IWM)

0.55%

13%

 Small-cap U.S. stocks
iShares Cohen & Steers Realty

0.70%

31.2%

 Real estate investment trusts
iShares MSCI EAFE (NYSE: EFA)

0.70%

2.7%

 Foreign developed economy stocks
iShares MSCI Emerging Markets (NYSE: EEM)

1.10%

16.4%

 Foreign emerging market stocks
iShares Barclays Aggregate (NYSE: AGG)

0.59%

7%

 Treasury, agency, and corporate bonds
iShares Barclays TIPS (NYSE: TIP)

0.55%

8.4%

 Inflation-indexed Treasury bonds
iShares Barclays 20+ Year (NYSE: TLT)

0.50%

10.7%

 Long-term Treasury bonds
iShares Barclays Short Treasury

0.50%

(0.3%)

 Short-term Treasury bonds

Source: iShares. Returns as of Aug. 31.

As you can see, the combination of domestic and foreign stocks, along with a wide range of bond investments and a REIT ETF, gives you a huge amount of flexibility to custom-make your college portfolio.

This flexibility does come at a price, though. In addition to the normal ETF costs that all shareholders pay, 529 plan participants also pay an extra 0.35% in expenses annually to cover program management and the state's administration fee. Those fees aren't terribly excessive, though, and compared to ETF-offering plans in Indiana, Iowa, and Missouri, Arkansas's plan has a lower range of annual fees, according to Standard and Poor's.

In addition, you're still subject to federal rules that apply to 529 plans generally. The biggest drawback is that you're only allowed to switch your investments once every year. However, by designating new contributions to go into particular ETF portfolios, you can slowly adjust your overall asset allocation in the direction you want it to go.

Get what you want
If you want to save for college but don't want to be locked into bad investments, take a close look at Arkansas's ETF-based 529 plan. Even at a slightly higher cost than ordinary ETFs, the tax advantages of using a 529 plan for your college savings could definitely make it worth the effort.

Stay tuned each Wednesday this month as Dan goes through the ins and outs of saving and paying for college.