As I mentioned in an earlier post, my wife and I were blessed with the birth of our second son eleven days ago. Believe it or not, my mind has already turned to the topic of college savings for our children, and I thought I’d share my research to date on the subject.
If you are not familar with 529 plans, you can think of them as 401k plans, but for college savings. They are an outgrowth of the original state-based, pre-paid tuition plans, which have since been adapted to become generic savings vehicles for college with significant tax advantages. There are other vehicles available, but none offer the combination of significant savings limits, tax benefits, college financial aid benefits, and control that the 529 plans offer.
Almost every personal finance journal now does annual reviews of each state-based 529 plan. Here is a great one from Money magazine that reviews them state-by-state.
When choosing a 529 plan, it is worth keeping the following things in mind:
- You do not need to choose the plan from your state. This is really important, because some of the state plans are terrible, with high expenses and poor fund choices. The ability to pick any state plan is a really great option for investors – imagine if you could pick among not just your company’s 401k plan, but the 401k plan from any company!
- Check to see if your state offers you tax advantages. Some states allow you to deduct 529 contributions from your state taxes. I live in California, which despite having a sky-high income tax rate, does not let you deduct anything. This is important, however, because in states with tax benefits, it might be worth sticking with the in-state plan.
- You can open one for almost any family member. Most people think about college savings only for their children, but 529 plans can actually be opened for anyone under 30. The whole point is that the person who opens the plan controls the money, but it only has tax advantages if used towards the college education of a person under 30.
- You are not locked in! You can actually change dependents on a plan once a year, and change state plans once a year. Don’t let the complexity stop you from opening a plan as soon as possible. It is very easy to change. Interestingly, you can use this ability to open a plan for your unborn children! Just open a plan for someone else, and once your children are born, switch the plan to them. A great way to get more than 18 years of compounded interest towards saving for college.
- The sooner you start the better. In the past 20 years, college tuition rates have grown at a compounded rate of 8%. The only way you are going to keep up with that type of growth is to save early, save often, and use the high expected return of investments like stocks to meet your targets. Compounding works best the earlier you start. The money you contribute in years 0-4 is likely 2-4x more valuable than the money you contribute in years 14-18.
- Expense ratios matter! Expense ratios are your enemy. This is money that is taken out of your investments, regardless of your return. A difference of 0.5% might seem small, but on $10,000 that is a loss of $4377 over 18 years. That’s real money. 529 plans often charge fees three different ways: on the funds, on the plan, and for the fund management firm.
- Save big dollars like a 401K, but withdraw tax-free like a Roth IRA! 529 plans really are the best of both worlds. You can contribute up to $12,000 per year (with a special $60,000 if you want to bundle 5 years of contributions at once). But if you use the withdrawals for qualified education expenses, you will pay zero tax on the earnings. So this isn’t tax-deferred saving… this is truly tax-free saving on all gains in the account. More details on this site.
- Save for retirement first. You can borrow money for college, but you cannot borrow money for retirement. College savings plans should only be put in place once your retirement savings plan is in place.
More tips from Money magazine and SmartMoney magazine are available.
When my son Jacob was born two years ago, I decided to open a Nevada 529 plan through Vanguard. Vanguard is known for its history of running low cost index funds, and for its tireless advocacy for investor rights. Vanguard actually runs plans for 13 different states, but the Nevada plan is the one that is fully integrated with Vanguard, which is an added bonus if you have retirement accounts with Vanguard (I do).
The expense ratios for the Nevada plan are good – depending on the fund, anywhere from 0.6% – 0.8% total. They also have a wide selection of investment choices.
However, last year I was disappointed to find out that Utah has an even cheaper plan run by Vanguard, with expense ratios closer to 0.4%. Of course, Utah charges a $25/year fee for out-of-state investors, but still, I started to think about moving Jacob’s plan over.
Then, yesterday, I get this letter from Vanguard. Given their commitment to low fees, they have reduced the expense ratios on the Nevada plan to 0.5% – 0.7%, still with no annual fee.
This is why I love to do business with firms like Vanguard. Their entire marketing message and differentiation is low fees. Like a company that always raises dividends on their stock, I firmly believe Vanguard is always working to lower the prices of their investment alternatives. They are like Wal-Mart for saving.
So, I’m sticking with the Nevada plan, and I’ll be opening one up for Joseph just as soon as I get his Social Security number. If you are interested in researching plans, CNN Money has a great set of recommendations (Utah, Nevada & Michigan top their list).
Update (1/21/2007): I’ve posted a new article on how to take advantage of the ability to change beneficiaries for 529 plans. Check it out.
Psychohistory 
Adam, what happens if you save up for college but the kid decides not to go? Is there a penalty for taking the money out? Basically, what if you decide not use the money for college for some reason?
congrats btw! . . .
this is probably the most useful blog post I’ve read in the last 4 month . . . 🙂
Hi Shri,
If your child decides not to go to college, then you have a few different options. The first option is to potentially reassign the account to another person who will go to college. You can change the assigned beneficiary once a year. You can even split an account into multiple accounts, and then reassign each new account to a new beneficiary.
I believe that if you withdraw the money for non-college expenses, then you are hit with federal income taxes on any gains, plus a 10% penalty, similar to what happens if you pull money out of a retirement account before age 59 1/2. Some state plans actually ding you for an additional penalty, but you could always switch your plan to a state that doesn’t.
Hope this helps.
Adam
Gotta make sure you understand the penalty. The 10% is only on any profit, if any. Many people think the penalty is on the entire amount.
A 529 is a no brainer for a grandparent. You get to a) take money out of the taxable estate and b) it is the ONLY exception that allows the GP to 100% revoke the $ with tiny penalties.
Hi Will,
People do seem to like my personal finance posts… I guess when your blogroll is all high tech, a practical post or two really stand out. I hope the information above is helpful.
Adam
Thank you for such wonderful advice!!! I too live in California and have a one and a half year old. I was hoping to invest in the ScholarShare (California’s plan) with fidelity but see it has quite expensive costs! (and there is no benefit to us poor Californians). If we are ever so lucky to get benefits with the California plan, are you able to switch from Vanguard to Fidelity? Are you doing an age-based fund with Vanguard, and if so conservative, moderate or aggressive? Or would you advise constructing your own portfolio? You advice is GREATLY appreciated! It’s so overwhelming, but the clock is ticking and I want to start saving that college money! Thank you so much, Robyn
One of the great things about 529 plans is that, once a year, you can switch the provider of the plan. So, if California ever does offer a tax benefit, it should be easy enough to switch over to take advantage of it. Of course, the tax advantage would only apply to new contributions.
I personally do the aggressive plan, as I like to see 100% of the plan assets in stocks, with a solid international weighting. I’ve been thinking about even moving it to the individually selected portfolios, to get a more aggressive mix of small cap & international stocks. For now, though, I’m 100% in the aggressive option.
I, of course, am not a financial advisor, so all I am giving here is my personal opinion about how I invest for my two sons education. I hope you find the information useful.
Adam
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Dear Adam,
I have been reading your blog for some time (thank you for many enjoyable posts!). I have really appreciated your intelligence and thoughtfulness on the personal investment issues. To my dismay, however, due to other work I’m doing, I have now discovered that Vanguard (the company you recommend for its 529 savings plan) is one of the 5 funds most egregious in its involvement with companies supporting the Sudanese government, and it is important to me NOT to help support that government and the genocide it pursues against the people of the Darfur region. Do you have any thoughts on that? Or on how to invest in a socially responsible manner in general, without being foolish with one’s money (especially if one is not very knowledgeable about these manners to begin with)?
Thank you so much for any wisdom you can take the time to share,
Annie
Hi Annie,
I’m not sure I have an easy answer here. In general, the concept of “socially responsible” investing has had a poor reputation overall, largely because the definition of socially responsible varies quite a bit between different people. For example, is it socially responsible to own Coca Cola? Through the 1990s, most socially responsible funds avoided Tobacco, Gambling, and Oil-related stocks. But they had no problems owning car companies, for example.
Personally, to date I have never specifically pulled out of an investment company or fund due to the stocks they own.
Do you think you could post a link to your reference to Vanguard supporting the Sudanese government? Or is the issue that Vanguard owns stocks of European companies, and European companies are notoriously close to Sudan?
I think Vanguard is extremely ethical, and likely only invests in companies that match the goals of the funds it offers. For example, if you tell Vanguard, “I want the best stocks in France”, they go buy the best stocks in France, regardless of whether or not those companies do shady deals with Iraq & Iran.
My bias would be to assume that Vanguard doesn’t seek out to invest in companies with Sudanese association, but that they are diligent in doing exactly what their investors ask them to do. A better path might be to avoid the Vanguard funds specifically that invest in these companies, if possible.
Hope that helps. I’ll think about it some more. I’m glad my blog is helpful. Let me know if there are other topics I could help with in terms of new posts.
Adam
Dear Adam,
Thank you for your reply. I do understand how difficult it is to invest responsibly, given the many different ethical principles one could have to attend to…hence the attractiveness of an investment company that promises to do all the work for one (like the Clean Yield Group or Women’s Equity Fund), but then there’s the worry that they are socially responsible but fiscally incompetent!
The website that had the data about Vanguard was:
Click to access USMutualFundsPetroChina.pdf
The issue seems to be the link between Sudan and China, a sufficiently embarrassing one, I gather, that the American Jewish World Service is planning a symbolic torch run from Darfur to Beijing (for the Olympics) to highlight the corrupt alliance.
It is true that only certain Vanguard funds seem to be implicated, so perhaps one (i.e. I) can make a statement by simply asking not to have one’s investment include those…
Thanks again,
Annie
Thanks for posting the PDF. I think I see the problem now.
It’s a specific company, PetroChina. Unfortunately, it’s one of the biggest companies in China, and thus any fund that owns any Chinese stocks seems to own that one.
You definitely could decide to not invest in any global fund that includes emerging markets like China.
Of course, the line in the sand is murky here too. Do you divest of other Chinese stocks that do business with PetroChina? With US & European companies that have partnerships with PetroChina?
I’m not sure this approach is the right one, either to make a difference in PetroChina behavior, or in investing your own personal portfolio. However, it’s a free market, right?
I think you’ll find that any Emerging Markets fund, or even large cap international fund, may end up with PetroChina shares.
Good luck with your efforts.
Adam
Hi Adam,
What do you think about IOWA plan (collegesavingsiowa.com)? Do you recommend this?
Thank You,
Raj.
Hi Raj,
It doesn’t look bad – a quick scan shows it has an expense ration of 0.52%, which is on the low side. Utah is still likely better, depending on the amount you are going to invest. I’m still in Nevada, due to pure inertia more than anything else. I haven’t filed to transfer the money yet. Nevada lowered it’s expense ratio to 0.5% as well.
I think the UPromise branded accounts are a little more expensive, due to the cut that UPromise is probably taking. Just a hunch.
Adam
I have 2 plans through upromise (i think its nevada) and an 8 yr old and 6 yr old. i have my 8 yr old on the conservative portfolio and my 6 yr old on the moderate portfolio. (i don’t know very much about investing and i wanted to see what they would do for a bit) they have not made any money yet, and holding pretty steady on the the losses but i really don’t know where to turn to in trying to decide how to invest for them. i am worried about the market today. do i keep them like this? or switch them out. i know no one can tell me what to do, but advice would be GREATLY appreciated. i would hate to see all their money just disappear. at this rate it seems like it is going to.
thank you, Bethany
Hi Adam:
2 years on, and your blog is still providing benefit:
Very clear explanation of the flexibility to change beneficiaries of 529 Plans, even to grandchildren, if need be!
On Nevada 529 Plan and Vanguard: I also have this investment for my 529 Plan, but I do it through Upromise, and get the added benefit of small additional contributions each quarter, based on various everyday items I buy. (BTW, I figure that Upromise gets some value from knowing my purchase patterns but that doesn’t bother me. Also, I’ve been with Upromise for 7 years, and I don’t think that any confidential personal data has ever been compromised.)