School is in session for those shopping for the best college-savings plan.

Morningstar of Chicago has just released its third annual list of best and worst 529 college savings plans in the country, comparing costs, performance, quality of underlying assets, investor flexibility and options.

Honors go to direct-sale plans sponsored by Alaska, Nebraska and Utah. For broker-sold plans, Morningstar recommends Colorado's Scholar's Choice program, South Dakota and Virginia's College America plan.

Class dunces include Alabama, Arizona's Pacific and SM&R Family funds, Nebraska's AIM fund, North Carolina, North Dakota and Wyoming's College Achievement.

"I hope that as more people become aware of 529 plans and the more visibility they get, the more competitive pressure they feel to bring down fees to manageable levels," said Kerry O'Boyle, co-author of the Morningstar report.

Competition has already kicked in. Created by Congress in 1996 and named after the section of the Internal Revenue Code that allows them, 529 college savings plans did not gain widespread popularity until 2002, when another legislative change made all contributions to the accounts totally Federal tax-free. Since then, the number of available funds and their assets have proliferated. By September 2005, investors had stored $60 billion in these accounts, a 40% increase over 2004.

Although the Federal tax exemption associated with the plan is scheduled to expire in 2011, most analysts agree that Congress will most likely renew the program and its popularity will continue to grow, said Arbab Hassan, a business analyst with 401kid, a education-focused financial planning company in New York.

In part, that's because the cost of college continues to rise. In the last decade, the price of post-secondary education has increased, on average, 5.11% per year, according to 401kid data. Projections from the College Board advise that if an investor has a child 10 years away from college now, by the time that child enters post-secondary school, the average cost for four years at a public college will top $90,000. Members of the class of 2020 who attend private schools can expect to pay close to nearly $200,000 for their diplomas.

Even if Federal tax provisions are not renewed, it still makes sense for those who do not think they will qualify for financial aid to start using 529s to save, said Pamela Greifeld Shortal, a financial planner with Sullivan Bruyette Speros & Blayney in McLean, Va. Not only is warehousing savings smart, but any assets or earnings withdrawn from the plan for educational costs will be taxed at the beneficiary's bracket, not that of the owner of the account. More importantly, well-managed funds should outperform the average annual rise in college costs.

"In essence, you have a tax-free loan from the government until the money comes out," Shortal said.

Meanwhile, 529 investors face an increasing number of options, and should consider each carefully. First of all, investors must take into account the ramifications of such savings on a student's potential financial aid application. The 529 plans represent a means for covering the cost of college and could shrink a student's potential financial aid reward. However, as financial aid is increasingly offered in the form of loans, having personal savings may make good sense. O'Boyle advises speaking to an accountant or financial adviser before opening an account.

Once an investor decides to open a 529 account, there are taxes to consider. Most states offer incentives to in-state residents. For example, the South Dakota Access Plan, one of Morningstar's favorites, waives a 0.35% management fee for state residents. California's Scholar Share College Savings Trust allows California residents to withdraw savings tax-free, while out-of-state residents' savings, and earnings, are subject to state tax upon withdrawal. Many other states also allow residents to deduct contributions from state income tax returns. Amounts vary from $1,000 per year through either Nebraska's AIM plan (ranked among Morningstar's worst) or its direct-sale College Savings Plan (ranked among Morningstar's best), to as much as $110,000 in states including Illinois, Colorado, New Mexico, South Carolina and West Virginia.

While the tax implications are important, investors should pay close attention to factors such as the portfolio of underlying funds, the costs associated with them and the number of choices available, O'Boyle said.

That's why Shortal, whose practice is in the best-ranked broker-sold plan state of Virginia, often recommends her clients buy into the Utah Educational Plan. Utah's plan, managed by Vanguard, is a direct-sale plan with broad selection and the lowest cost ranking in the country. Although choosing this out-of-state option means that Shortal's clients forfeit home-state tax benefits, it's worth it, she said. "When you look at that tax benefit, and then compare it to the lower expense ratio, they can do just as well as if they were to go with Virginia's plan," she said.

Morningstar slams both the Arizona Pacific Funds 529 and the Family College Savings Plan. "High costs, the lack of an age-based option and poor investment choices make these options unappealing on almost every level," O'Boyle wrote. "Arizona ought to follow Wyoming's lead in eliminating these terrible options."

Wyoming, which appears on this year's worst list, announced last month that the state plans to eliminate its plan, which charges 0.90% in management fees and had only $17 million in assets. Participants' assets would be rolled into Colorado's Scholars Choice College Plan, which is managed by Smith Barney and ranked among Morningstar's "best."

But not all states have shuttered sharply criticized plans.

"Plans are competing for out-of-state dollars," said Arman Rousta, founder and chief executive of 401kid. What states make off of out-of-state investors goes into the treasury, and is often earmarked for public education costs.

Claims of high fees and poor choice caused New York State to switch administrators for its 529 Direct plan. In September 2003, New York hired Vanguard and Upromise to manage its accounts. Costs dropped and inflows rose.

"Not only do you have to put a good product together, but you have to put a good marketing plan together, too," Rousta said.

In Rhode Island, solid marketing helped the tiniest state in the union sponsor one of the country's biggest plans.

While states scramble to court outside investors, they also struggle to keep those they have. Illinois, for example, not only offers deductions as high as $110,000 per year for residents, but if a resident chooses an out-of-state plan, Illinois levies a state tax on their earnings. In addition, if an Illinois 529 investor moves that money to another state's plan, Illinois again levies a state tax, O'Boyle noted. At the same time, the Illinois plan offers only six investment options, none of them especially attractive, according to O'Boyle. "Investors are in a quandary," he said.

But keep watching, said Rousta, as lists like these put pressure on various plans to improve their options and cut costs. "The competition is fierce, and these kinds of reports certainly fuel the fire," he said.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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