Tips for Creating a 529 Plan

A 529 plan is an easy way to invest in your child's education, while also enjoying some tax advantages. Originally intended for post-secondary education, 529 plans can now be used for K–12 education costs. And, since the passage of the SECURE Act in December 2019, they can also be used for student loan payments. Here's how to get started.

1. Check Your State's Plans First

All 50 states and the District of Columbia offer one or more 529 plans. You don't have to invest in your own state's plans, although that might entitle you to a tax deduction or credit. More than 30 states provide such tax breaks.

Seven states currently offer tax breaks regardless of which state's plan you invest in. They are Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.

A number of independent websites, such as Savingforcollege.com, periodically rate the best state 529 plans based on their investment performance and other factors.

2. Compare Plan Fees

One reason to invest in an out-of-state 529 plan is that you may get a better deal on fees. You can find information on a plan's annual fees and compare plans side by side on the College Saving Plans Network website, which is affiliated with the National Association of State Treasurers.

That difference in fees can really add up over time. If you invest $10,000 on the day your child is born, it will be worth $39,246 on their 18th birthday if you assume an 8% return with 0.1% internal fees. If those fees are 1.1%, the same 8% return will only grow to $32,746. "That's free money you're just leaving on the table that could be spent on your child's education," says Brian Preston, a certified financial planner with Preston & Cleveland Wealth Management in McDonough, Ga., and host of The Money Guy Show, a finance podcast.

Fees vary substantially between direct plans, which are sold directly to account owners, and advisor-sold plans, which are sold by brokers and other financial advisors. New York's 529 College Savings Program Direct Plan, for example, currently has annual fees of 0.12%, while New York's 529 Advisor-Guided College Savings Program has fees of 0.53% to 1.24%.

So, if you're comfortable making your own investment decisions, you'll save substantially by investing through a direct plan.

3. Consider Savings Plans vs. Prepaid Plans

There are two basic types of 529 plans: savings plans and prepaid tuition plans. Fewer than 10 states currently offer prepaid tuition plans, but if your state is one of them, it will give you the opportunity to lock in future tuition costs at current prices. Bear in mind that prepaid plans can limit your choice of schools, typically to that state's community colleges, colleges, and universities. With a 529 savings plan, you can use the money at any eligible institution in any state—and for a wider range of expenses, including room and board.

Prepaid plans also differ widely in what kinds of guarantees they offer, so be sure to read the fine print. Prepaid plans cannot be used for K–12 education.

4. Choose Your Investments

Once you've picked a plan, your next step is deciding how you want your contributions invested.

Most plans offer a selection of mutual funds, such as stock and bond funds, ranging from conservative to aggressive. Some also offer other options, such as guaranteed investment contracts (GICs) from insurance companies and certificates of deposit (CDs) from banks. You don't have to put all of your money in one type of investment; you can diversify among several.

As a general rule, the more years until the account beneficiary will need the money for education, the more aggressively you might want to invest. The reason is that you'll likely receive a higher return over time and also have more time to recover if the financial markets take a tumble.

Many 529 plans now include age-based or target-date funds that adjust their asset allocation over the years, becoming more conservative as withdrawal time nears. If you aren't comfortable choosing investments—or don't want the hassle of reallocating your 529 portfolio periodically—these funds can be a smart choice. Just make sure their fees are not too high.

5. Invest Early—and Often

The sooner you can get started, the better. As mentioned, you can start a 529 plan either through an advisor or, less expensively, by investing directly with the plan's sponsor. While states administer 529 plans, they typically turn over the day-to-day operations to major financial services companies, such as Fidelity, T. Rowe Price, or Vanguard.

Unlike most mutual funds, 529 plans typically require no minimum investment or a very small one, such as $25.

For subsequent contributions, many plans also offer automatic investment programs that will withdraw whatever amount of money you choose from your bank account on a monthly, quarterly, or semiannual basis and invest it in the plan. One advantage of investing periodically throughout the year, rather than in a lump sum, is you'll benefit from dollar-cost averaging. Some plans and employers also allow you to have money automatically withdrawn from your paycheck to go into a 529 plan.

Automatic plans like these make investing almost effortless, which can be a particular boon to busy parents.

The Bottom Line

The most important thing with any savings plan is to start as early as possible and do the research. Most people begin looking into tax-advantaged 529 plans shortly after the birth of their first baby. The research may seem daunting because of the myriad of 529 options, rules, and regulations. The Internet has all of the information you need, but if you're stuck, talk to a financial planner.