Understanding 529s

A friend asked me how he should save for his daughter’s college education. (His daughter was born in 2009, which means probably I should be asking him the personal finance questions, but whatever.) “A 529 college savings plan,” I said.

529s are great, I explained: you put in after-tax money and it grows tax-free. You can put a lot of money into them; the money can be used for tuition, room, board, textbooks, and other fees; there are no age or income limits; and you can change the beneficiary if your kid decides to attend the school of hard knocks instead of college. (Although, heck, these things are so flexible, the School of Hard Knocks is probably a qualified educational expense.) If you have a child, you should have a 529.

“Okay, but which 529?” asked my friend, who lives in Vermont. “The Vermont one?”

“Uhhh,” I replied. Not only did I not have a good answer to this question, but I realized that I didn’t know whether my own six-year-old daughter’s 529 was any good. Answering my friend’s question turned out to be pretty easy. As for my own child’s future, well, I’ll tell you what I’ve figured out so far.

A messy system

You’re familiar with the Roth IRA, right? Maybe even have one of your own? Part of what makes the Roth such a handy investment vehicle is that it’s just a generic tax-advantaged box for putting your savings in. You can open a Roth with any financial institution and put any kind of investment or deposit account in it. Easy.

Now, imagine if the Roth IRA system were administered by the state governments, and each state could implement its Roth in an entirely different way. Imagine further that you didn’t have to invest with your own state’s fund, that you could choose nearly any of the 50 state Roths. Fifty states, 50 different (sometimes wildly different) plans.

Given this absurd situation, I’m guessing you’d do one of two things: go with your state’s Roth, regardless of whether it was a good investment, or throw up your hands and vow to choose a good plan someday, but not today.

Roth IRAs aren’t like that, but 529s are. The morass exists because 529s were invented by the states about 20 years ago and eventually blessed by the Internal Revenue Code in their current form in 2001.

“It does create a messy system,” says Joe Hurley, CPA and founder of savingforcollege.com.

It sure does. Choosing a 529 is harder than getting a group of friends to agree on a restaurant. So let me help narrow it down for you.

Choosing a 529: the basics

• If you pay state income tax, check whether you can get a tax credit for contributing to your own state’s plan. A list of those states can be found on FinAid.org. If you qualify, it’s like having the state drop a sack of doubloons onto your porch. “In Oregon, for example, we have a 9% state income tax rate, and so if you put $10000 into a plan, you’re going to get $900 back,” says Eric Lochner, a certified financial planner at McDonald Franceschi in Portland, Ore. “You can think of that as an immediate 9% return on your investment.” My Vermont friend gets a $250 tax credit every year for socking at least $2500 into the Vermont 529. It’s a no-brainer. Bonus: Some states, such as Pennsylvania, give you a tax deduction for contributing to any 529 plan. Check the Finaid.org page linked above.

• Otherwise, look for a plan with low fees. Some 529s have such a high expense ratio, they should be called the Cash Under the Mattress Fund. Lochner recommends the Utah or Nevada plans, which offer low-cost Vanguard funds.

• Conservative investors should consider the Montana 529, which lets you invest in a CD whose interest rate is pegged to the tuition and fees inflation rate at private colleges. You can’t lose principal, and if average tuition skyrockets, so do your earnings.

Prepaid tuition plans

This is the plan that resembles a pension, and it’s the plan my family is in right now. My wife and I both graduated from University of Washington. We would like our daughter to go there, too. It’s a good school and it’s near our home, so she could visit us anytime.

Washington’s 529 plan, which is called Guaranteed Education Tuition (GET), lets us buy credits at UW now. For every 100 GET units we buy, our daughter gets a full year at UW, guaranteed. You’re not buying the credits at today’s rate, however. Right now, a year at UW costs $7700; a year’s worth of GET units is $10,100. You can use the money to attend other schools, but it always pays out at the current UW tuition rate.

What do the experts think of prepaid plans? “In theory, they should work great, because they satisfy a need that many families have simply to put the money away now and not have to worry about tuition inflation,” says Hurley. “But they come with a lot of rules. It’s very difficult to understand exactly what you’re paying for and how much it’s costing.”

Lochner is even more skeptical. “Every time I read about them, it sounds like they’re riddled with problems,” he says. “They can run into underfunding problems and unfunded deficits in the future.”

A prepaid plan is a good idea if you want to buy exactly what it’s selling: tuition at the colleges listed on the back of the box. If my parents had expected me to attend a specific college, though, I would have told them to bite me. Since Washington has no state income tax and I have no interest in biting anyone, I’m going to invest with either the Nevada or Montana 529 in the future.

Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.