3 keys for finding the best 529 college savings plan

Recently, I recommended 529 college savings plans as perfect gifts that keep on giving. Now I’d like to offer a vetting process you can use to find the best plan for your family.

What should you look for? Three words narrow that down: compatibility, cost and consistency.

Why 529 savings plans and not personal investment accounts? The best reason is that these state-sponsored programs are already set up with portfolios of mutual funds. In many states, you’re offered a state income tax break for contributions. And in every case, plan withdrawals aren’t taxable -- if the money is used for college expenses.

The best plans are compatible with what you need to do. If your home state offers a tax break, take it. You’re getting an incentive that’s aligned with saving for college. I went out of state for programs for my two daughters because at the time I opened them, my home-state program had no incentives and was badly managed. 

Then pick an option that matches your investment style. An “age-adjusted” portfolio will automatically lower portfolio risk as your child gets closer to college. Or you can pick individual mutual funds.

The second piece of the 529 vetting process is cost, which gets a little more complicated. The annual expenses on the mutual funds within the plans can vary from zero to more than 1 percent annually. And adviser-sold plans may have separate fees and commissions.

When it comes to costs, the simplest rule is choose the least expensive funds in a “direct-sold” plan. That means avoiding brokers and advisers, and sticking with the largest, low-cost fund companies.

Want to drill down deeper on costs? Consult the savingforcollege.com fee study and explore the most- and least-expensive options within the state programs you’re considering. Generally, the most expensive funds hold stocks, and the least expensive vehicles hold cash or bonds. 

How much can you expect to spend on management expenses within a 529 plan depends on the state and its private manager. The takeaway here is to spend as little as possible on plan expenses. That way, more of your money is invested.

The least-costly plans offering stock funds are in New York, Michigan and Iowa, where 10-year expenses range from $205 to $331. That compares to $2,115 from the District of Columbia’s most-expensive option. 

Unlike cost, which is fairly easy to understand, consistency is more difficult to vet.

Although long-term returns of 529 funds can vary widely, most people tend to look at short-term results. That’s asking for trouble because no fund manager can guarantee decent returns from year to year.

Look for funds that perform uniformly well over one- to 10-year periods. That shows which managers are generally producing above-average returns over the short and long term.

In perusing some of the most consistent performers from the quarterly savingforcollege.com survey, a few plans keep making the cut. Alaska’s plan, managed by T. Rowe Price, made the top-10 performance list for one, three, five and 10 years. 

Also making the top-performer’s list over those periods were plans from New York and Michigan. Over a decade, the best-returning plan was from Utah. 

What do they have in common? They generally employ relatively low-cost managers who run passive index funds. That includes companies like Vanguard and Dimensional Funds. 

The better performers also are direct-sold, so you don’t have the burden of a commission eating into your college investment.

Even though I’ve pared 529 plan shopping to just three factors, you have a lot of data to crunch when comparing them. And because you can invest in a plan from any state, comparison shopping can get a bit gnarly.

As a rule -- if for no other reason than to simplify matters -- check out your home-state plan first. Unless you’re in a state with no income tax like Florida or Texas, you might get an income tax break just to invest. That will certainly lower your upfront costs.

If your state doesn’t have any incentives -- or it’s high cost -- then shop around. I would dog-ear programs that feature low-cost fund companies mentioned above.

At the very least, acquaint yourself with the powerful math of 529 plan investing. Say you have a 5-year-old who will attending college in 13 years and college costs are rising 4 percent a year. The total tab for a four-year degree for this child will be about $177,000. That’s if you’re paying the entire bill. I know, yikes!

But let’s say you saved $599 a month in a 529 plan. You’d be able to cover the entire cost when that child enters college -- that’s assuming an annual return of 6 percent.

Do your own cost projections to see the approximate future college costs, but don’t get freaked out. The number will be obscene. However, it doesn’t include the possibility of tuition discounts, scholarships or other financial aid. 

Keep in mind you can also enlist grandparents and other relatives, who can also make direct contributions to your child’s 529 plans.

With college savings, the most powerful strategy is to plan ahead while saving regularly. And with careful vetting of low-cost, consistent programs, you’ll put more of your money to work over time.

That’s not only a reward that will ease your family’s future financial burden but one that provides an even better gift: peace of mind.