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:

1. 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!
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.