Confused about the difference between 529 plans versus Coverdale plans or college savings in general? So was I, so I researched and wrote this article as a way to educate myself (and hopefully you) on the topic of college savings.

My son Ben just turned one year old as I write this. He had the mandatory birthday party and received presents and a decent amount of cash from relatives.

We deposit all of his money into his passbook savings account. His mother opened it; I really didn’t want it as it’s not a terribly good investment. The account pays less than 1% interest which is less than a third of some of the better savings accounts like the one I have from HSBC.

source: http://flickr.com/photos/jon_tucker/577736727/

Our financial adviser of course recommended a 529 or a Coverdale plan. Each has its unique advantages. I found a pretty good comparison chart at savingforcollege.com. The biggest difference between the Coverdale plan and the 529 is that the Coverdale may be used for K-12 (primary and secondary school) before 2011. However for college savings the 529 gets most of the press these days.

Both plans work very much like a Roth IRA. You put your money in after tax. The withdrawn earnings are tax free as long as they are used for educational expenses (books, tuition, fees, etc). There is something about tax free earnings that really brings a smile to my face.

I’ll talk mainly about the benefits of the 529 plan as that one seems to be far more popular. Many plans allow you to contribute more than $300,000! That’s a pretty good sum of money working for you tax free. You can change the beneficiary to another relative. That’s right you can change the beneficiary but it has to be a relative. If the many is not used by the original beneficiary, it can sit in the account for an indefinite amount of time in most cases. So if your child didn’t go to school you could keep the money in the program until your grandchild or great grandchild went to school! There are no income restrictions unlike a Roth. There is a penalty of 10 percent on the earnings if you withdraw you money from the program.

The one thing I don’t like about these types of plans is it has to be for education. This is what is making my decision so tough. If I were planning a large family I wouldn’t hesitate to make the contributions but with only one child and no plans for another, I’m taking a risk that he will attend some kind of post-secondary school. It’s a pretty good risk as both my parent’s, my siblings and aunts and uncles on my father’s side all went to some form of college.

You need to watch out for are plans that are college or state specific. These really limit your options. I couldn’t imagine telling my son where he must attend school. What if he wanted to go to a school that specialized in a certain field? It might be something that doesn’t even exist today. Choosing your child’s college before they can even speak is a great Pygmalion project.

However, with the above criticism of the education focus I think that 529’s are a good deal. Now I just need to pick which one I want. My state has a 529 plan with low fees if and is not limited to residents of South Dakota. The expense ratios actually appear somewhat reasonable. You’ll pay in the range of 0.41% to 0.64% for age based portfolio (it gets more conservative the closer to college your child gets) and 45% to 0.85% if you want just the asset based plan.

Our current financial adviser offered us a plan through Edward Jones but I’m not sure that was best financially for us. The state sponsors this plan and appears to be picking up part of the tab for managing it. In that kind of scenario I’m not sure I can continue to trust this adviser. Is she looking out for us? If so why wouldn’t she have recommend the state plan?

My other dilemma is going with the investments in the state 529 plan versus having something with Vanguard. In the ideal scenario I would ideally like to have the Vanguard Total Stock Market Index in a 529 account that I could use for tuition in any state. Looking at the Nevada Vanguard 529 Savings Plan provides just the option I described. You can in fact choose to own the Vanguard Total Stock Market inside this 529. However the expense ratios are higher (0.50% to 0.70%) than Vanguards normal offerings. The Total Stock Market Index fund normally carries a .15% load (which is fantastic) compared to the .50% load it carries under the 529 plan. Obviously there are some additional expenses for the management of the funds but we need to make sure the tax benefits out way this additional cost which they easily should.

So finally comparing the rate of return of my two choices (choice one is the state 529, choice 2 is the Nevada Vanguard 529) we see a difference.

-Results as of 1/31/2008
*0-4 year old bracket of Age Based Plan

From this table you can see that the actively managed CollegeAccess 529 has beaten the market in the short turn and has come very close to matching it in the long run. The Vanguard 529 matches the market (as it’s supposed to) minus its expense ratio.

Now it’s time for a reality check. Do I believe in index funds enough to accept the lower returns over the last five years? Before I can answer that I will consider another 529 index fund from Vanguard: the vaunted Vanguard 500 Index.

-Results as of 1/31/2008
*0-4 year old bracket of Age Based Plan

Again we see that the actively managed beats the index fund over the (relative) long run and the short run. However, we shouldn’t see this as a general indictment of index funds. Vanguard normal (not 529) index funds have lower expense ratios. Also some the CollegeAccess529 fees are picked up the tax payers of South Dakota. So someone else is footing the bill to provide those nice returns.

Both the Vanguard 529 and the CollegeAccess 529 are free from sales loads and other expenses, excluding those fees accounted for in the expense ratio. This is good as we aren't wasting money with a financial advisers sales fees or any other such performance killers. The CollegeAccess 529 is relatively efficient for and actively managed fund and it's expense ratios only decrease with time. If you chose the age adjusted option then the investments become more conservative as the beneficiary approaches matriculation (graduates high school and goes to college). Hence the decrease in the expense ratio.

At this point I think I’m pretty much convince that I’m going to use the instate CollegeAccess529 plan. The minimum is $250 compared with $3000 in the Vanguard account. Considering I’m not completely sold on the idea of funding junior’s college I want to start slow. Investing his gift money plus a small monthly automatic deduction would be a good start.

I have to say that if I were in another state without a good 529 plan, the Vanguard appears to be a very good choice. Remember, you can transfer money between 529 accounts like you can do with regular retirement accounts. So if you move or find a better deal, as I understand it, you should be able to roll over your account. This adds a lot of flexibility as college approaches. If your son or daughter wants to go to a specific college you could perhaps roll over the money to that state or institutions 529 if there are any advantages.

In conclusion 529’s are an incredible deal especially if you have a large family or many relatives. It’s great for grandparents who have many grandkids so that they can be sure the money will get used by someone in the family.

Who doesn’t like tax free savings?

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