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How to Choose the Right 529 Plan to Save for College
A 529 plan is a great way to save for your child’s college education, but it can be challenging to figure out which plan you should use.
529 plans are a little strange in that they’re run by individual states, but there’s no requirement that you use your home state’s plan. And given that almost every state offers at least one 529 plan, and some offer multiple plans, there’s a lot of information to sort through.
So, how can you choose the right 529 plan for your needs? Let’s break it down.
Four Factors to Consider
There are four main factors to think about when evaluating 529 plans:
- State income tax deduction: While you don’t get a federal income tax deduction for contributions to a 529 plan, some states offer a state income tax deduction if you contribute to your home state’s plan.
- Fees: Cost is the single best predictor of investment performance, so you’ll want a plan that minimizes fees.
- Investment options: Ideally, you’d like to find a plan that offers a solid lineup of index funds, given that they’re low-cost and have been shown to outperform actively managed funds over most time periods.
- Ease of use: Your 529 plan should be easy to use, all the way from opening the account to making contributions, choosing investments, and eventually using the money for education expenses.
With those factors in mind, here’s how to choose a 529 plan.
Step 1: Check for a State Income Tax Deduction
Before you do anything else, you’ll want to understand whether your state offers an income tax deduction for contributions to your home state’s 529 plan, and, if so, what the terms of that deduction look like.
The website FinAid offers a good starting point for your research here: State Tax Deductions for 529 Contributions.
You can scroll through the list, find your state, and see what kind of deduction it offers. Here are a few of the variables you’ll come across:
- No deduction: Some states, like California and Massachusetts, don’t offer a state income tax deduction. Other states, like Florida, don’t even have an income tax to begin with. If your home state doesn’t offer a deduction, you can skip to Step 3 below.
- Deduction limits: Most states that do offer a deduction have an annual limit on the amount of money you can deduct. There may be a separate limit per beneficiary or there may be a single limit per household.
- Carryforward ability: If you contribute more than the limit in a given year, some states – like Connecticut – allow you to carryforward the excess contribution to be deducted in future years. In other states, that excess contribution can never be deducted.
- Tax credit: Some states – like Indiana and Utah – offer a tax credit instead of a tax deduction. This could be more or less valuable depending on the specifics of your tax situation.
- State plan requirement: While most states require you to use your home state’s plan in order to get the deduction, a small number of states – like Arizona and Pennsylvania – offer the deduction regardless of which state’s plan you use.
You should also look up your state’s income tax rates so you know exactly how much money you’d be saving with a deduction. Bankrate has a good resource for looking that up here: State tax rates.
It will usually make sense to contribute to your state’s plan up to the maximum deductible amount, but there are a few more variables you’ll want to evaluate before making that decision. We’ll look at those in Step 2.
And remember, if your state doesn’t offer an income tax deduction, you can skip right to Step 3.
Step 2: Check Your Home State’s 529 Plan Fees and Investment Options
An income tax deduction is great, but there are situations in which it can be outweighed by high fees and the lack of good investment options.
North Dakota is a good example of this. Married couples filing jointly can deduct up to $10,000 of contributions to North Dakota’s 529 plan each year, which is a lot. But there are two factors working against that:
- North Dakota has a relatively low state income tax rate, ranging from 1.10% to 2.90%. This reduces the value of the deduction.
- The investment options within North Dakota’s 529 plan are relatively high-cost. According to the plan description, their portfolios have expense ratios of 0.55%. Compared to New York’s 529 plan that has investment portfolios charging just 0.16%, North Dakota’s 529 plan could cost you hundreds or thousands of dollars after 10+ years of investing in those higher-cost funds.
The bottom line is that you want to make sure your home state’s plan offers good, low-cost index funds before deciding to take the deduction. If it doesn’t, you’ll have to run the numbers to see if it’s better to put your money elsewhere.
The most reliable way to find your plan’s fees is to go directly to the 529 plan’s website and search for its program description. This is a long document that tells you everything you could ever want to know about the plan.
There will always be a section in that document on fees that spells out exactly how much you’d be paying. There will also be a section on the investment options so you can make sure they match what you want.
Step 3: Find the Best Out-of-State Plan
If your home state doesn’t offer an income tax deduction, or if your home state’s plan is high-cost, you’re free to choose from an entire country’s worth of 529 plans.
And while that gives you a lot of options, it also puts the burden on you to sift through those options and make a good choice while evaluating a number of competing variables.
You can certainly do that work yourself, but to make it a little easier for you we’ve compiled a short list of 529 plans that offer high-quality investment options at a low cost:
- New York: If you want simplicity and low fees, New York’s 529 plan is hard to beat. They offer a solid lineup of Vanguard index funds, a good mix of age-based options, and all of their funds cost just 0.16% per year.
- Utah: Utah’s 529 plan costs slightly more than New York’s, but it comes with more flexibility. There are more funds to choose from – including DFA funds that are typically only available through a financial planner – and you can even create your own customized age-based fund.
- Michigan: Depending on how you want to invest, you may be able to create a slightly cheaper portfolio with Michigan’s 529 plan, where fund costs range from 0.12% to 0.24%. Michigan’s funds are offered through TIAA-CREF, so if you prefer them to Vanguard then this would also be a good choice.
Making the 529 Choice Simple
In the end, choosing a 529 plan really comes down to three things:
- Does your state offer an income tax deduction for contributions to your state’s plan?
- If so, does the deduction outweigh the possibility of getting higher-quality, lower-cost investments through one of the stand-out 529 plans mentioned in Step 3 above?
- If you don’t get a deduction, you’re free to choose one of the three 529 plans mentioned above, or any other plan that you find meets your personal needs.
And take heart in the fact that no matter what you decide, the fact that you’re saving for college expenses means that you’re ahead of the game.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.