Help a Reader: Which 529 is Best?

Here's a question I received recently from a reader:

We are trying to decide how to best start a 529 for a newborn. We have plenty of cash we could allocate to a plan, and are trying to decide whether to start the plan with a bigger initial investment or larger annual contributions. Can you provide some info on how you went about starting & maintaining your 529's? Any specifics would be much appreciated!

Here's what I've had to say on the issue:

• 529s Are the Undisputed Kings of College Savings

• Why 529s Make Sense

• FAQs on 529 College Savings Plans and Why 529s are a Good Deal

Any other thoughts for this reader? What would you advise him to do?

Comments

[Kevin]

I started mine directly through my state's (Missouri) website. No broker commissions to deal with that way. And I'm invested in one of the Vanguard investments that has ultra-low expenses.

There is a provision currently that allows you to contribute $60,000 to a 529 with no gift tax consequences (even though it is over the $12,000 annual limit) if you elect to treat the contributions as spread over 5 years. But note, you cannot give any other gifts to the beneficiary.

I set up 529's for 2 kids. When they were young, I asked family for the cash they would spend on gifts so I could deposit into their accounts. as they get older, I'm sure they will want the presents. I set the accounts with TD ameritrade. At the time, I opened the accts they weren't deductible in my state. They are now but the performance for the in state plan (TIAA CREF) isn't as good as Ameritrade. Twice a month I have money deducted from my checking acct that goes directly into 529. I have also set up Roth IRA's for my kids. When colleges calculate financial aid, Roth's aren't calculated at the same ratio as a 529.

[Matt]

Even if your own state's plan isn't all that great, you can actually get into a plan through other states. Usually only your own state's plan will let you take a state tax deduction though. I would always recommend that over going through a brokerage since you avoid fees.

As for how to structure the contributions, it depends on your risk tolerance. You can get rid of a lot of risk by spreading out the contributions, effectively dollar cost averaging. On the other hand, you potentially give up a lot of returns by delaying entry to some of the money. For long term investors, time IN the market is more effective than timING the market.

Since you have the cash, there's an even more powerful technique than dollar cost averaging: value averaging. The idea behind this is that on certain dates (say, every 2 weeks) the account value should reach a certain amount. You put in however much money is needed to make that happen. That way, after the market has had a bad 2 weeks, you put in more money, and after the market has had a good 2 weeks, you put in less. It gets you to buy low and sell high to an even greater extent than dollar cost averaging.

An example might make value averaging clearer. In this case, the goal is to make the account value go up by $1000 every two weeks, no matter what the market does.
Week 0, contrib $1000, acct value $1000
Week 2, 4% mkt rtn, contrib $960, acct value $2000
Week 4, -6% mkt rtn, contrib $1120, acct value $3000
Week 6, 5% mkt rtn, contrib $850, acct value $4000

Hybrid approaches are also possible. $20,000 immediately, and value average the rest in over 18 months, for instance. This way you're splitting the difference between the market risk mitigation of value averaging and keeping the money in the market for more time.

[Matt]

I've run a few experiments in Excel to test the methods. Unsurprisingly, the risk level of dollar cost averaging (DCA), value averaging (VA) and initial lump sum (LS) investing correlates positively with the expected return.

The more stable the investment, the more likely LS is to come out on top. An investment has to be very risky before LS is less likely to win than either DCA or VA.

VA gives a slightly better return than DCA for slightly more risk. LS is a lot more risk than both and a lot more return.

Given what a pain VA is to implement, I wouldn't really consider that seriously as an option given its small edge over DCA.

Ultimately, my suggestion is to go with a hybrid between DCA and LS. You just have to decide what percentage of your cash to put into each. If you're doing one of those 18-year plans most 529 plans offer, I'd probably go 75% LS/25% DCA over a year. If you find a 529 that lets you do emerging markets, it would look more like 40% LS/60% DCA. But that's just my intuition. This isn't based on rigorous study of real data or anything.

[FMF]

FYI -- here's a great general piece on 529 plans a reader sent me:

http://biz.yahoo.com/brn/071003/23025.html?.v=1