How to make sure more of your college savings go to your kid and less go to Wall Street

A popular way to put aside money for a child's education is to open a tax-free 529 savings plan. Nationwide, these accounts contain more than $250 billion, donated by parents, grandparents, and others.

These savings plans offer state and federal tax benefits, but the trouble is not all 529 savings plans are created equal. Not all of them are good deals, and some unsophisticated parents are at risk of choosing plans with high fees that will eat up a large fraction of their investments.

Looking through the documentation for all 48 states (and the District of Columbia) that offer 529 plans, I've found which funds offer the best deals. Parents should also watch out for major pitfalls as they choose a 529 plan. In an age of rising college costs, parents simply can't afford to save money for their children's college education with a bad deal.

First, make sure a 529 savings account actually makes sense for you

Photo by William Thomas Cain/Getty Images

The first question parents should ask themselves is whether they should contribute to a 529 plan at all. Indeed, financial experts say that for most families, it makes more sense to focus on maxing out contributions to retirement accounts — like a 401(k) and an IRA — before they contribute to a 529.

There are two reasons for this. One is that having more money in a 529 account can reduce the amount of financial aid a student is offered, whereas a parent's retirement accounts are excluded from financial aid calculations.

Second, building up a retirement account offers more flexibility down the road. A parent with ample retirement savings can always have a child take out loans and then help the student pay them off later. But if you wind up with extra money in a 529 account, there may be no way to transfer the cash to a retirement account without paying tax penalties. A Roth IRA is particularly useful in this respect, because you can take contributions (but not earnings) out of a Roth IRA at any time with no tax penalty.

Still, there are some cases where putting money into a 529 account makes good sense. If someone else — like an uncle or grandmother — wants to contribute to a child's education, it probably won't work to suggest contributing to the parent's retirement account instead.

Also, many parents find the idea of saving for a child's education more inspiring than saving for their own retirement. So even if contributing to the retirement account is a better idea in theory, the 529 account might work out better in practice because parents are more likely to actually set money aside in a 529 account than in an IRA.

Look for low-cost funds

529 plans are run by states, and parents are not required to invest in their own state's plan (though there may be tax advantages to doing so). On top of that, many states offer a variety of different fund options. The result: an overwhelming number of choices.

Many states offer age-based funds. These funds invest in riskier, higher-return assets when the child is young, then shift to safer options as the child nears high school graduation. These funds are a good option for the average parent who doesn't want to become an expert on mutual funds.

More importantly, parents should look for the funds with the lowest costs.

Some mutual funds have teams of Wall Street analysts trying to find the best stocks to invest in. The others, known as index funds, simply buy every asset in a broad category — like the 500 largest companies in the stock market. Index funds have lower costs, which they often pass on to customers in the form of lower fees.

You might think it's worth paying extra for someone to choose the best stocks, but research shows this is wrong. Stocks chosen by professional stock pickers do no better, on average, than the market as a whole. Indeed, once you subtract the higher fees these funds charge, actively traded funds tend to actually do worse than index funds.

So the most important variable in choosing a 529 plan is its cost, known in industry jargon as the "expense ratio." The best mutual funds have expense ratios below 0.2 percent. Some funds have expense ratios above 1 percent. To put that into perspective, if you invest $10,000 in a fund with a 1 percent expense ratio, you'll be wasting $80 every year compared to a fund with a 0.2 percent expense ratio.

Every state's 529 plan should clearly disclose these costs. They might be labeled "expense ratio" or "total annual asset-based fees" — these are two terms for the same thing.

Never buy through an adviser

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In most states, there are two ways to sign up for a 529 savings plan. You can talk to a financial adviser who will help you make the investment, or you can invest directly on the plan's website.

Buying a 529 plan from an adviser is almost always a bad idea, because most "advisers" are actually salespeople. Like car sellers, they earn commissions based on the plans they sell, and that means they probably have a financial incentive to steer you toward more expensive plans.

And those higher commissions are ultimately paid by the customer. Adviser-sold 529 plans tend to have higher fees than the identical plan sold directly from the 529 plan's website. And these aren't one-time fees, either. If you invest in an adviser-sold plan, you could wind up paying higher fees every year until your child starts college.

So if you need financial advice, it makes more sense to hire a fee-only adviser — who charges customers directly — rather than an "adviser" who makes a living through commissions. Fee-only advisers aren't cheap — $250 per hour is a typical rate — but you may wind up wasting a lot more than that if you put your savings into high-fee mutual funds. And if you can't afford a fee-only adviser, then you really can't afford to sign up for an adviser-sold fund that will cost you extra every year for a decade or more.

Check to see if your state offers tax deductions

Most states have opened their 529 plans to investors nationwide, creating a competitive market among state plans. The tricky thing is that more than 30 states offer tax breaks for 529 contributions that are only available to residents who invest in their own state's plan. You can see a map showing which states offer which kinds of tax breaks here.

If your state offers a tax break and has an age-based 529 program with low expenses (click here to see information about your state's plan), then your choice is easy.

Conversely, if you live in one of the states that don't offer tax breaks — or your state offers tax breaks for in-state and out-of-state 529 plans, then you can invest in one of the best plans nationwide (more on that later).

Things get tricky if you live in a state that offers a tax break for in-state 529 plans but only offers expensive plans.

For example, I live in Washington DC, which offers 529 funds designed for children ages 0 to 5, and another for children ages 6 to 10. Unfortunately, these funds have fees of 1.09 percent — more than 6 times the cost of low-cost plans elsewhere in the country. These fees decline as the child get older but are still 0.55 percent — three times the most affordable plans in other states — for the 17-year-old version of the fund.

These fees would be assessed every year I had money in the plans, so the value of money I invested for my infant daughter this year would be reduced by almost 17 percent by the time she was ready for college. On the other hand, DC allows parents to deduct up to $4,000 in 529 contributions from their DC tax bill — a deduction that would be worth 8.5 percent for me.

So if I were contributing to a 529 plan this year, it would probably make sense for me to open the account in a low-cost state like New York or Michigan. On the other hand, if I had a 10-year-old daughter, I'd be paying those high fees for fewer years but getting the same 8.5 percent tax break. So in that case, contributing to the DC plan might make sense.

Unfortunately, there's no general rule that works for everyone — the best plan will depend on how expensive your own state's plans are, how generous your state's tax breaks are, and how old your child is.

Five excellent 529 plans

If you live in a state that doesn't offer special tax breaks for choosing your own state's 529 plan, or you decide that your own state's plans are too expensive to be worth the tax break, then you can choose from dozens of state plans across the country. Here are five of the best plans, offering low fees and convenient age-based investment options:

• New York's NY 529 Direct Plan has a 0.16 percent expense ratio. Click here to sign up.
• The Michigan Education Savings Program has funds costing between 0.14 and 0.24 percent. Click here to sign up.
• The Utah Educational Savings Plan has funds costing between 0.17 and 0.22 percent. Click here to sign up.
• Nevada's Vanguard 529 Savings Plan has funds costing between 0.19 and 0.49 percent. Click here to sign up.
• Wisconsin's Edvest plan has funds costing between 0.14 and 0.43 percent. Click here to sign up.

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