For residents of states like Maryland, Alaska, New York, Colorado and Ohio, choosing a 529 plan is simple.
Each of these states boasts a high-performing 529 plan and extensive tax benefits on account contributions, so residents can simply throw their funds in the account and let the nest egg build.
The rest of us might need to look to other states' 529 funds or – depending on state taxes – forget about 529s entirely.
Here is what you need to know to make the right decision.
Why 529 plans are exciting
To help families save up for advanced education, the federal government provides the ultimate in tax breaks to 529 plans. That is, your contributions to a 529 plan are untaxed, and your account withdrawals are untaxed when they are applied to qualified education expenses of a designated beneficiary. Basically, the funds you set aside for your kids' college are untouched by the IRS. That makes 529s uber-competitive with other financing options. It's like telling the Arizona Diamondbacks they will play every game in Chase Field (their home field).
Not every 529 is exciting
But let's face it: if you put the Houston Astros in Minute Maid Park, year-round, you might still not have a winner. Not every 529 will outperform mutual funds, even with the Federal tax advantage. So if you want to pick a winner, then you need to know what the winners look like, as well as how they play.
Popular 529 Features and their Returns
One of the first options you will see: direct-sold or advisor-sold funds. The primary difference between between these two types are who can buy them. Advisor-sold 529s can only be purchased by financial planning professionals. Anyone can invest into a direct-sold fund.
Advisor-sold funds were supposed to provide higher returns because they would be chosen by professionals, but their returns have been sub-par. They charge higher fees, which has done more harm to their overall return than good. In its 2013 report on 529s, Morningstar gave direct-sold programs a rating of 3.3, on average, as opposed to a 2.5 for advisor-sold programs.
You also want to differentiate open-architecture, as opposed to closed-architecture plans.
When some management teams choose their investments, they make their choices from a single asset-management firm. These are defined as closed-architecture strategies because by comparison, they choose from a more selective field than open strategies, which may choose from multiple asset managers. In a strange twist of fate, open plans have been found to be less effective in terms of their 5-year annualized returns.
My opinion on this matter is still pending. There seems to be an inherent fault in the data, because it makes more sense that increased options would yield greater flexibility and better results. And looking at the data, open plans have slightly outperformed in the last 3 years. It is possible the housing crisis and global recession skewed the long-term data. But using the data at this point, closed-architecture plans are your way to go.