Net Gains: Save Money for College, Tax Free

April 23, 2008 — -- Nebraska just can't seem to get its act straight.

For the third consecutive year, the Nebraska AIM College Savings Plan was named one of the worst 529 college savings plans by Morningstar, the Chicago-based investment research provider.

On the other hand, the Maryland College Investment Plan, Virginia College America and Colorado Scholars Choice programs made return appearances on the top of Morningstar's annual Best and Worst 529 College Savings Plans list released last week.

A 529 college savings plan is a state-sponsored program used to accumulate funds to pay future higher education expenses. Thanks to significant tax advantages, the 529 plan has become the preferred investment vehicle for college savings.

Funds in a 529 plan accumulate tax free and then if used to pay higher education expenses, incur no income taxes on withdrawal. No income limit exists on those wishing to contribute. There is no federal deduction for 529 contributions, but more than 30 states offer some type of state tax break on contributions.

The popularity of 529 plans has soared in the last two years after Congress approved a tax change that made permanent the tax advantages of 529 plans. Before the 2006 change, tax free withdrawals from 529 plans had been scheduled to expire in 2010.

In its annual ranking of the best and worst 529 plans, Morningstar evaluates the plans for diversification, fees, flexibility and quality of the underlying mutual funds.

In the five years it has been doing its annual study, Morningstar said 529 costs have come down, weaker plans have improved the mutual funds they offer and ineffective plan administrators have exited the 529 plan business.

Typically, individual states decide to sponsor one or more plans and then select investment firms to operate them on their behalf.

The Nebraska AIM College Savings Plan appears on the worst list for the third consecutive year because it remains too expensive compared to its peers despite changes made last year, according to Morningstar.

Joining the Nebraska plan as the worst 529 plans are the Ohio Putnam College Advantage plan run by Putnam Investments, two Mississippi plans run by TIAA-CREF and New York's 529 College Savings Plan operated by UPromise.

The five best plans as ranked by Morningstar are the Maryland College Investment Plan run by T. Rowe Price, Virginia Education Savings Trust administered by the Virginia College Savings Board, Virginia College America operated American Funds, Illinois Bright Start College Savings Program run by Oppenheimer Funds and Colorado Scholars Choice College Savings Program managed by Legg Mason.

In four of the five worst plans, Morningstar cited high fees as one of the main reasons families should avoid these plans when deciding where to invest money for future higher education expenses.

"Lower costs mean less taken out of an investor's returns," Morningstar's report said.

Selecting the right plan, however, can be difficult, while falling into the wrong one can happen easily, particularly if you live in Nebraska or one of the other states cited on Morningstar's worst list.

The natural tendency of parents investing on their own is to select the plan sponsored by their own state. Sometimes that is the right choice; sometimes it is not.

Luckily for Nebraska residents, the AIM College Savings Plan is not the only 529 plan offered by that state. The state offers two other plans, including the College Savings Plan of Nebraska, which, Morningstar says, "has become an even more attractive choice for state residents."

In looking to your own state's plans, first check total costs, including plan management fees, account fees, expense ratios for the individual investment choices and then possibly commissions if you're buying through a broker.

If the costs appear high, then check to see if they are outweighed by any tax break offered by your state. The size of deduction varies by state.

If you live in a state like I do -- Massachusetts -- that offers no state tax break, then you should feel free to roam the entire 529 landscape looking for what you think is the best overall 529 plan.

Keep in mind there are two varieties of 529 plans: direct-sold and broker-sold. A direct-sold plan is one you invest in directly yourself with no upfront charge. Broker-sold plans are purchased through a broker who receives a commission for the sale.

My preference is for direct-sold plans. There are good broker sold plans, such as the Virginia College American plan featuring American Funds, but if I were a Virginia resident, I would opt for the direct-sold Virginia Education Savings Trust. Why pay the 5.75-percent charge for the Virginia College American plan?

For more on your state's 529 plans and possible state tax breaks, you can visit the personal finance section of Morningstar.com to find summaries and reviews of each individual 529 plan. More information on 529 plans is available as well from Savingsforcollege.com and Collegesavings.org.

A little research can set you on the right path to college savings and investing. My guess is that path will not lead you to the Nebraska AIM College Savings Plan, at least until more changes are made.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com