Do 529s Pay?

By Barbara Kiviat

Saying that a 529 Savings Plan is the best way to invest for your kids' education is like saying there are good shows on TV. It may be true--if you hit the right channel at the right time.

The basic case is this: 529s let you invest money without having Uncle Sam reach in each year and tax your earnings. Thanks to the magic of compounding, a yearly investment of $3,000 that grows, say, 7% annually, to $38,632 after 10 years, could grow tax free to $44,351, according to Robert Matricardi at T. Rowe Price. (You also don't get taxed when you spend the money, though that little bonus will run out at the end of 2010 unless Congress extends it.)

Unfortunately, 529 plans come in all stripes, and plenty of them are so ill constructed that they seriously eat away at your tax benefit. To make a 529 worth it, you need to avoid three main pitfalls.

Don't buy through a broker Those middlemen typically take an up-front commission--something like 5% of the money you invest. Over 10 years, that $3,000-a-year investment thus becomes $42,133--or $2,218 less. If the advice you get is worth that price, great. If not, consider a plan sold directly to investors. Kerry O'Boyle, an analyst at investment tracker Morningstar Inc., recommends Alaska's T. Rowe Price College Savings Plan and the College Savings Plan of Nebraska. (Just be aware that if you buy an out-of-state plan, you may be giving up state tax breaks and other perks for residents.) Beware exorbitant expenses In addition to whatever you might pay a broker, you'll pay annual management fees (which help run the plan) and expense ratios (which help run the underlying mutual funds). Every dollar you pay is a dollar less you'll have available to spend on tuition. So look at plans that have management fees of less than 0.5% and shoot for one that's closer to half that. Expenses on the underlying investments shouldn't be more than 1%. This will knock a lot of plans out of contention, but that's O.K. In the end, you're going to be left with only one plan anyway. Ultra-cheap plans include the Utah Educational Savings Plan and New York's 529 Savings Program.

Don't forget that 529s are investments There is risk in any 529 fund and, in most cases, no guarantee that you won't lose money. Pick a plan that has a range of investments, from stocks to a money-market fund or other cashlike option, so that you can move into safer securities as your kids get older. (In other words, you shouldn't be loaded up on tech stocks when Junior is, well, a high school junior.) Most plans you buy directly (i.e., without a financial adviser) include age-based portfolios. That means the fund company decides how you should be investing at each stage and automatically redistributes your assets.

Of course, you're free to skip the 529s if you determine that you'll be paying more in fees, expenses and loads than you'll save in taxes. That calculation will take some research and number crunching, but remember that this is your kids' education--probably the most important thing you'll ever buy.

> For more about picking college savings plans, visit time.com/529