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The Best and Worst 529 College Savings Plans

Our annual look at the state of the college savings industry.

It has been another year of substantial change, much of it for the better, within the fledgling 529 college savings universe. Since our last review in February 2006, significant improvements on the tax front--on both the state and federal levels--have enhanced the appeal of 529 plans relative to other college-savings vehicles. In addition, management upgrades and fee reductions at a number of plans show that states are getting serious about providing competitive options for investors saving for their children's education.

Tax Changes
In the 529 world, the big news of 2006 was the signing into law of the Pension Protection Act of 2006. Among its many features, it made permanent the changes to Section 529 of the federal tax code made by the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA)--including investors' ability to withdraw earnings from 529 plans, free of federal taxes, for qualified college expenses. Until passage of the law, federal tax breaks on 529 plan earnings were set to expire at the end of 2010, casting a shadow over one of the most appealing aspects of these plans. Now, with that uncertainty removed, college savers can invest confidently in 529 plans knowing that their earnings will remain tax-free into the future.

The new tax law did not make permanent the EGTRRA changes to Coverdell Education Savings Accounts, however. Thus, unless Congress acts to address the college savings issue again, contributions to Coverdell accounts will revert to a maximum of $500 per year (down from $2,000) after 2010, and withdrawals for elementary or secondary school expenses will no longer be allowed without penalty. Coverdell accounts can still be rolled over into a 529 plan at any time, but the long-term appeal of these accounts now pales to a large extent in comparison with 529 plans.

On the state level, Maine, Kansas, and Pennsylvania all passed so-called "tax-parity" laws in 2006, which extend each state's tax deductions on contributions to residents who invest in out-of-state 529 plans. Previously, the standard practice had been to extend state tax breaks only to those who stuck with one of the home-state plans. It's unclear, however, how much traction this trend will gain among states, many of which have historically doled out benefits to encourage participation in their home-grown plans. Seven other states have reportedly considered similar legislation in the past, with nothing to show for it thus far. In general, we favor such tax-parity because we think it empowers investors with greater flexibility to choose investment options more suited to their needs and personal risk tolerances. Still, tax parity is potentially a double-edged sword for college savers tempted to flit back and forth or chase performance, or for those persuaded to take their tax break and go out of state to a more expensive or conceivably worse plan.

Quality Is Improving
Despite some ongoing issues concerning broker sales practices, occasionally byzantine disclosure documents, and layers of fees, 529 plans have in general improved over the past few years. Since 2004 Congressional hearings on some of the above issues and industry concerns about less-than-expected asset growth, the states seem to have taken to heart the need to offer more competitive offerings. Until recently, few parents were tempted by 529s, given that so many featured lackluster offerings, high fees, and added complexity. Thus, wholesale changes have occurred at a number of plans in recent years.

Indeed, four of the seven plans from our 2006 worst list no longer exist or have changed providers. As expected, Wyoming got out of the 529 business entirely by merging its plan into Colorado's offerings. Arizona closed its high-priced PF and SM&R plans to new investors pending their eventual liquidation. And North Dakota dumped its poorly diversified Morgan Stanley plan for another of the seemingly ubiquitous Upromise/Vanguard options.

The trend toward lower fees also continues. The disappearance of high-priced plans, like that from Wyoming and South Dakota's Core4College, has eliminated some of the most egregious offenders. The arrival of new providers with lower-cost options, not to mention a handful of fee cuts at other plans, has sparked an increased measure of price competition among the states. That escalated to what one might call a price war in the fall of 2006. The planned introduction of a 0.50% all-index age-based option in California by Fidelity prompted Vanguard to cut fees by 10 basis points (0.10) at its flagship Nevada plan to match it. Plus, economies of scale from industry-wide asset growth have also helped to push costs down at a number of plans.

Compiling Our List
Still, with more than 80 plans available from 48 states and the District of Columbia, there remain a number of holdouts. We can't emphasize enough the impact that high costs have on long-term performance, which can potentially outweigh the benefits of state tax breaks on deductions as well as cause providers to take on more risk in an effort to boost returns to overcome their expense hurdle. Proper diversification and sound asset allocation also remain critical for investors facing such a finite savings period and rapid drawdown time for these assets.

Thus, as before, our best and worst lists are built around these crucial characteristics as well as the quality of underlying investments, the flexibility of the investment options, clarity of the program disclosures, and the investment managers' record of treating shareholders well--based on Morningstar's Stewardship Grades. (While we don't give Stewardship Grades to state 529 plans, we consider the grades of the primary provider and the underlying fund options where applicable.)

As always, we recommend that investors look first to their home-state plans for additional incentives such as matching grants and state-tax deductions on contributions. The widespread availability of state tax deduction calculators on the Internet can help investors determine how much some of those benefits are worth. While these incentives can be meaningful, they don't necessarily overcome the disadvantages of a poor or costly plan.

Without further ado, here are this year's top 529 plans, as well as six to avoid.

The Best

 Best 529 College Savings Plans
Colorado Scholars Choice*Legg Mason
Maryland College Inv PlanT. Rowe Price
Nebraska College SavingsUnion Bank & Trust
Utah Educational SavingsUtah (Vanguard)
Virginia CollegeAmerica*Virginia (American Funds)
* Broker Sold

We've made only minor changes to our best list from last year. The Maryland College Investment Plan run by T. Rowe Price edged out the Alaska T. Rowe Price College Savings Plan after the Maryland plan eliminated its enrollment fee and cut its program management fee to 0.28%. The plans are almost identical, and the Alaska plan remains a fine option for those who already invest there, but the overall lower annual asset-based costs of the Maryland age-based options and that state's tax breaks on contributions earn it the nod.

The Utah Educational Savings Plan Trust remains among our favorites for its low costs, sound age-based options, and tried and true index and international offerings from Vanguard. True, a number of states offer Vanguard index options as part of their plans, but we think Utah continues to provide the best combination of cost and flexibility for investors.

Nebraska's College Savings Plan administered by Union Bank & Trust also offers low-cost index funds from Vanguard but supplements them with actively managed offerings from American Century, Fidelity, and PIMCO as well--all at a decent cost. We like the flexibility of the plan's four age-based tracks, which we think will suit the risk tolerances of most investors, plus the availability of six static portfolios and 21 individual fund options.

Our favorite plans for investors using a financial advisor or broker continue to be Virginia's CollegeAmerica and Colorado's Scholars Choice. Steady, reasonably priced, and long-term focused funds from American Funds are the key attractions of the Virginia plan, by far the largest 529 plan in the country. Brokers have the full lineup of the shop's funds to choose from in crafting a portfolio for their clients. The Colorado plan underwent a makeover after the acquisition of asset manager Salomon Smith Barney by Legg Mason in December 2005, but that has only served to improve the plan. Now, investors here have access to noted Legg Mason manager Bill Miller, as well as offerings from small-cap specialist Royce Funds and fixed-income stalwart Western Asset Management--both subsidiaries of Legg Mason.

The Worst

 Worst 529 College Savings Plans
Alabama Higher Education 529Van Kampen
Alaska John Hancock Freedom 529John Hancock
Missouri MOST 529 AdvisorUpromise
Nebraska AIM College SavingAIM
West Virginia Cornerstone SMART529Hartford
West Virginia Leaders SMART529Hartford

The Alabama Higher Education 529 Fund and Nebraska's AIM College Savings Plan again make our list of worst plans. Alabama, as the last holdout, did finally pass legislation in 2006 making earnings from 529 investments free of state tax for residents, but only if they invest in the home-state plan. Although the state waives its program and state fees for residents, more than 90% of assets come from out of state. Those nonresidents pay the full 1.35% to 1.63% in annual asset-based fees for a clunky age-based program and lackluster lineup of Van Kampen funds. While AIM has announced an overhaul of its age-based portfolios in the Nebraska plan for March 2007, investors are still paying a pretty price (1.35% to 1.61%) for an aggressively allocated, growth-leaning option with some weak and unproven underlying funds.

We're also singling out the broker-sold Alaska John Hancock Freedom 529 plan for its exorbitant fees. While we think highly of the standout lineup of underlying funds from T. Rowe Price, Davis Advisors, PIMCO and others, and the asset-allocation scheme is sound, the annual fees of 1.41% to 1.70% of assets for the age-based plan are nearly double that of direct-sold T. Rowe Price alternatives. Those high costs come from a 0.75% program fee for the Class A cost structure, which includes a 0.25% distribution fee. That distribution fee is disappointing as a number of the underlying holdings invest in fund A shares instead of cheaper institutional share classes; the A shares already levy 12b-1 marketing and servicing fees as ongoing compensation to financial advisors and broker/dealers.

Both the Cornerstone SMART529 and Leaders SMART529 plans from West Virginia land on our worst list for a similar reason. A 0.34% administrative fee and 0.30% annual distribution fee layered on top of underlying A shares add up to total yearly asset-based costs of 1.59% to 1.71% and 1.65% to 1.79%, respectively, for each plan's Class A age-based option. Some uninspiring underlying funds, plus the lack of dedicated small-cap exposure and limited mid-cap and foreign diversification, also limit the appeal of these plans. West Virginians, who enjoy a full state-income tax deduction on contributions to home-state plans, have better options within the state.

Disappointingly, a new plan rolled out in May 2006, Missouri's MOST 529 Advisor, also makes our list for its high costs and mixed bag of underlying investments. The plan doesn't offer an age-based option, instead providing 24 funds from which brokers can construct portfolios suited to their individual client needs. Again, though, a 0.30% program management fee and 0.25% distribution fee for the Class A shares are piled on top of mostly more expensive A fund shares. Indeed, the total annual asset-based costs for the individual fund options range from 1.22% to 2.70%, including a rich 1.45% for the plan's three ETF offerings. Missouri does offer a state tax deduction on 529 contributions to the home-state plan, so residents have good reason to consider the state's direct-sold option.

More Information
Of course, sorting through the myriad of 529 choices remains a daunting task. To learn more about your home-state plan or to compare data and performance of the many options available, check out our 529 home page and click on the name of the plan of your choice.