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How to select the correct 529 college savings plan

Finding the best way to save for college can be daunting. States offer 84 tax-advantaged 529 college savings plans and more are on the way.

Not sure exactly what a 529 college savings plan does? You're not alone.

Nearly 3 in 4 investors don't know what a 529 plan is, according to a recent survey by the investment firm Edward Jones. Sallie Mae, the largest private student lender, found that only 16 percent of parents used 529 plans or other college savings options for the 2015-16 academic year, down from 17 percent a year ago.

The lack of awareness is unfortunate because the plans are chock full of tax benefits. Investment earnings in a 529 plan are not subject to federal capital gains tax and generally not taxed by state governments when used for the qualified education expenses, such as tuition, fees, books, as well as room and board, of the designated beneficiary.

Thirty-three states and the District of Columbia sweeten the deal by giving residents a tax break if they invest in their state's 529 plan. Five states — Arizona, Kansas, Missouri, Montana and Pennsylvania — offer a state income tax deduction to residents for any 529 plan contributions.

"Looking at your state's plan is a good starting point," said Brett Tushingham, a certified financial planner at Tushingham Wealth Strategies, who specializes in college planning. "But don't let the tail wag the dog, so to speak."

Savingforcollege.com, a website that rates 529 plans, has a calculator to determine how much a plan's state tax deduction or credit is worth to you.

State tax breaks also can change. For example, North Carolina ended its state tax deduction for 529 contributions in 2014. And if you live in a state that doesn't have a state income tax, the plan's costs and investment options are more important considerations.

Beyond the tax benefits, investors should know about the two types of 529 college savings plans: those sold directly by the states and those sold through financial advisors. (To make matters more confusing, there are also 529 prepaid plans that allow account holders to buy tomorrow's tuition at today's prices at in-state public colleges and certain private schools.)

Direct-sold 529 plans generally have lower investment fees than advisor-sold ones. (See table below.) However, advisor-sold plans tend to offer more investment options than direct-sold plans.

Morningstar recently released its ratings of 529 plans and no advisor-sold plan received the investment research firm's top "gold" rating. The three plans that grabbed the rating — Nevada's Vanguard 529 College Savings Plan, the Utah Educational Savings Plan and the Virginia529 inVest — mostly had low-cost index options on their investment menus.

Two-thirds of assets invested in 529 plans are in age-based portfolios, which automatically increase their bond holdings to become more conservative as your child reaches college age.

"It's important for investors to understand how their age-based portfolios work," said Leo Acheson, senior analyst at Morningstar and lead author of its annual 529 ratings.

Some age-based portfolios gradually shift from stocks to bonds and cash little by little while others can reduce their equity exposure suddenly by more than 10 percentage points in a single day, "We like that more gradual approach because it exposes investors to less market-timing risk," Acheson said.

In a low-interest-rate world, a hefty allocation to bonds and cash in age-based portfolios will do little to boost your college kitty as your child approaches high school graduation.

"The age-based funds for several of the most popular 529 plans are half cash by the time the child is age 16 and almost all cash once the child is in college. Since the money will be spent over four years, you're going to see a minimal increase in value over those six years," said Andrew Tupler, CFP, a financial advisor at Commonwealth Financial Network in Bridgewater, New Jersey.

Even with conservative investment approaches, assets in 529 plans continue to grow. Total plan assets rose to an estimated $242.7 billion as of June 30, reflecting a 3.4 percent increase from a year ago, according to financial research firm Strategic Insight. (See chart below.)

Sadly, 529 plan assets may not be enough to blunt the rising cost of a college education.

The median 529 plan account balance was $14,005, according to Strategic Insight. That would cover less than one year of in-state expenses at the average public, four-year college.

Brian Boswell, vice president of research and development at Savingforcollege.com, said getting an early start on college savings is more important for investors than picking the very best plan.

"They shouldn't get overwhelmed by the choices. They should just invest," he said.