529 Plans: Making a Good Thing Better

Every state in the nation now offers a 529 plan, but unlike the citizenry, all plans are not created equal. If the Founding Fathers were investing for their children's education, in fact, they'd likely be aghast. Some states have residency requirements; some don't. Some plans allow participants to invest directly; others are exclusively broker-sold.

More importantly, investment options vary widely from plan to plan, which means that it pays to do your homework, just as you would when considering a mutual fund for any other investment-savings account, such as your 401(k) or an IRA. The same basic questions apply, after all. True, most 529 plans allow donors to choose between "static" and "age-based" portfolios. But the underlying funds in those portfolios will succeed (or fail) for all the usual reasons, including the tenure and stock-picking acumen of the management team, the team's ability to craft a careful balance between risk and reward, and the plan's price tag.

Another key difference among plans can lie in the area of taxation. Most states follow the federal government's lead in exempting qualified withdrawals from income taxes, but a number of states sweeten that deal by exempting plan donors' contributions from state income taxes as well. Some even allow exemptions for the full amount. Thus, as Langdon Healy explained in an earlier column, investors should mull the advantages at home before venturing beyond their states' borders.

One difference, in fact, may make an in-state plan nearly irresistible. In a small handful of cases--Louisiana, Michigan, and Minnesota, to be exact--the state provides a compelling incentive to invest at home: a contribution match, up to a certain limit. Similar to employer matches on employee contributions to 401(k) accounts, the significance of this feature can be summed up in two words every serious saver loves to hear: Free money.

Still, even if you're lucky enough to live in a state that provides one, a 529 match doesn't necessarily make the decision to invest at home a complete no-brainer. Consider the case of Louisiana's 529 offering. The amount of the state match is determined by an income-based sliding scale. The less you earn, the more the state kicks in, up to a very generous maximum of 14% of your contribution. (The minimum match is 2%.)

So far so good, but a closer look at the state's investment options reveals at least one serious flaw: Louisiana's 529 plan only allows participants to invest in fixed-income instruments. Over the long haul, bonds aren't likely to deliver the same bang for your investment buck as stocks, making the plan a poor choice for donors whose beneficiaries have a long time horizon before entering college. And the plan is even less appealing for high-income earners in Louisiana who could only avail themselves of the lower end of the state's matching scale.

Fortunately, the state is considering adding equity options to its 529 investment mix. That's certainly good news for Bayou State residents, but what should you do if, say, you live in a state with a pricey plan that doesn't provide a match--or even a state-income-tax exemption on donor contributions?

Well, you could always write your congressman. The Founders would be proud of you, and, by rights, your friendly neighborhood representatives should be anxious to help you out. After all, how many initiatives actually give them a chance to argue that they've supported education by cutting your tax bill and investment fees?