Is a 529 plan right for your family?

Jar full of money labeled college fund

Most of us want our kids to have a shot at college.

But tuition is outstripping inflation, and the only way you'll ever pay for it — or even a portion of it — is to start putting money aside as soon as possible.

So one of these state-sponsored, tax-free college savings plans might be exactly what you need.

But before we get to that, let's pause for a surprise.

The first step in saving for your kid's education is to save for your own retirement.

There are many ways to pay for college, but you can't get a loan or scholarship to see you through your golden years.

Marilyn Plum, a certified financial planner, says it's sort of like dealing with an airborne emergency. You have to put on your oxygen mask first before you can save your child.

"Sacrificing your retirement for your child's college is not a wise thing to do," says Plum, director of portfolio management at Ballou Plum Wealth Advisors in Lafayette, California. "You don't want to have to depend on your children later in life."

What does that mean in practical terms?

You should be stashing at least 10% of your gross income in a 401(k) plan where you work, or in a Roth IRA, before you commit any of your money to college savings.

Once you've done that, a 529 plan is worth considering.

"It's one of the best ways to save for college because you get tax advantages, good investment options and it's easy to contribute," says Joe Hurley, founder of Savingforcollege.com.

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You can join a 529 plan in any state regardless of where you live.

Plum says it's important to start saving early so you can enjoy years of compounding.

Start with only $50 per month at birth, average a 7% return and you'll have $20,000 by the time your child is a senior in high school.

"You want to start saving something because the compounding effect can add up over time," Hurley says. "When you get those statements every quarter, it will also be a reminder to keep saving."

Although these are state-sponsored plans, they're typically administered by large investment firms such as Fidelity, Vanguard and TIAA-CREF. As a result, there are literally hundreds of options to choose from.

So where do you start?

Hurley says you should first look at your state plan to see if there could be any tax benefits.

Everyone who opens a 529 plan benefits on their federal income taxes because earnings and withdrawals are tax-free, as long as the money goes to educational expenses.

But many states also allow residents who enroll in one of their 529 plans to deduct contributions from their state taxable income. That's an incentive to go with an in-state plan.

Let's say you're going to contribute $2,000 per year to the plan and have a 5% effective state tax rate. That's $100 in additional annual savings.

If, on the other hand, there's no state income tax where you live — Florida, Texas and Nevada, for example — then there's no specific advantage to signing up for an in-state plan.

Do the math to see if it's worth it. You'll also want to factor in the fees and quality of the plan in your state.

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Minimum initial investments range from nothing to $250, and while there are usually no limits on how much you can contribute each year, most 529 plans cap the total amount you can accrue in your account at $235,000 to $400,000.

(While there may be no annual contribution limits, there are restrictions on how much can be deducted on state tax returns. There could also be gift tax implications with the IRS if your contributions exceed $14,000 in a single year.)

Visit Morningstar or Savingforcollege.com, where you can compare plan requirements, contribution limits, investment options and fees.

Morningstar designates "Gold" 529 plans as having great investment options, solid management and reasonable fees. Its four top-rated plans for 2014 were:

These might be a good place to start if you have no tax advantages in your own state.

Most plans have a few to a couple of dozen investment options, ranging from conservative to aggressive asset allocations.

Plum says you should evaluate any 529 plan investment options just as you would a mutual fund.

Start with fees.

Most plans have a variety of small fees, including an administrative fee, an account maintenance fee and a program maintenance fee. There are also expenses in the underlying investments.

Direct-sold plans, which are dominated by index funds, tend to be the cheapest.

Morningstar reported that the average expense ratio for a direct-sold, passively managed, age-based track investment in 2014 was 0.36%.

Next, look at available investments.

Most have age-based options that act like target date funds and change the allocation of stocks and bonds as the child gets older.

Much as in retirement, you need both. Stocks provide growth while bonds provide stability.

Generally, you want more in stocks when the child is younger, then move more into bonds as college nears.

The Morningstar survey noted that at age 0, the average equity allocation is 80%, and by age 19, it's only 10%.

Your best bet is this age-based allocation because it adjusts automatically, giving you both the growth and protection you need.

If you feel you can do better, most plans have a variety of funds ranging from aggressive growth to conservative allocations.

Some parents have concerns about what happens if their child doesn't go to college. If that's the case, 529 plans can be rolled over to other children in the family without penalty.

But be aware that any earnings not spent for educational costs will be subject to a 10% penalty and income taxes when the account is closed.

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