College savings plans are more popular than ever.  The number of 529 accounts, named for Section 529 of the Internal Revenue Code, grew by nearly a million between December 2010 and June 30, 2012, when they reached 10.98 million, according to the College Savings Plans Network’s 2012 midyear 529 report. Total invested 529 monies in June were hovering near $180 billion.

The rate of 529 investing is rising, too. In just the first half of 2012, $14.16 billion was added to these accounts, nearly doubling the entire 2011 increase of $7.43 billion.

The average account size has reached an all-time high, too. It was $16,298 on June 30, 2012, a 6.2% increase over the 12 months before.

One reason for the popularity of these plans is the increasing cost of college, which is rising faster than the rate of CPI inflation, according to Maria Bruno, a senior investment analyst at Vanguard’s Investment Counseling and Research group.

Until 2006, these plans, named after Section 529 of the Internal Revenue Code, were set to lose the tax-free withdrawal features that made them so alluring. A sunset provision would have ended the tax-free qualified withdrawals in 2010. Then the Pension Protection Act of 2006 made them permanent.

What’s more, new bonus features on these plans have begun to kick in this year. Now, parents and grandparents can contribute $1,000 more, up to $14,000, to a student’s 529 savings plan without paying a gift tax. Also, a maximum five-year contribution, up to $65,000 for each child, can be made all at once. And contributions made by grandparents won’t count as parents’ income on federal financial aid applications. As of this year, students are also free to spend 529 distributions on technology, for instance on laptops and Internet services (within certain limitations, of course).

Fund costs have dropped as well. Vanguard, for instance, dropped its expense ratio on some 529 funds to 0.25%.
John Miley, of Ronald Blue & Co.’s Indianapolis office, says many of the clients he counsels begin making 529 contributions when their children are toddlers. His Indiana residents can take a 20% state income tax credit on contributions up to $5,000, for a maximum $1,000 credit.

“That’s like getting a 20% return on your investments before you’ve even earned any results,” he says. “States do this to encourage residents to invest.”

While only 529 plan investors who owe income taxes to Indiana can apply that credit, some states, such as Arizona, Kansas, Maine and Pennsylvania, allow their residents to claim a state income tax deduction for contributions paid to other states’ 529 plans.

Most states offer their 529 plans to out-of-state families, says Brenda Bautsch, a Denver-based senior policy specialist with the National Conference of State Legislatures, a bipartisan policy center based in Denver and Washington, D.C. Funds withdrawn for college-approved tuition and expenses, regardless of state or federal district, are free from federal income taxes.

For example, Miley says Ronald Blue has a lot of clients who use the Nebraska state plan if they don’t have income tax incentives in their own states, because Nebraska offers a menu of Vanguard plans through its CollegeChoice 529 Direct Savings Plan. As of January 31 of this year, Vanguard was managing almost $44 billion in 529 plan assets in 28 college savings plans and five prepaid tuition plans, in 30 states, according to Bruno. (Prepaid accounts allow parents to buy tuition credits at an institution in advance.)

Nebraska also offers a plan sold through advisors: the CollegeChoice Advisor 529 Plan. Direct-sold plans still outnumber advisor-sold 529 plans. (In 2011, there were 59 of the former and 36 of the latter, according to the Financial Research Corporation.) As of October 2011, Morningstar put the average 529 expense ratio for advisor-based plans at 1.47%, nearly three times as much as the 0.54% ratio for plans sold directly.

However, advisors also say that there can be good reasons to go with an advisor-directed plan, even with the higher expense ratios. Franklin Templeton, for example, offers scholarship money through its advisor-directed plan in New Jersey.

Perry Weyser’s tax and financial advisory firm, Goode and Wyser, in Ocean Township, N.J., offers the advisor-directed Franklin Templeton 529 College Savings Plan. The expense ratio for this plan is 5.75% for accounts of $50,000 or less, says Weyser, and the rate drops to 4.50% for accounts between $50,000 and $100,000. He has about 50 clients in 529s. “If clients live in a state that gives them a deduction for contributing to the state-run direct 529 plan [New Jersey doesn’t], then that is a smart investment,” he says. “If the state they live in doesn’t give them any tax break for the contribution, or their state doesn’t have a direct plan, then they should consult with a financial advisor.”

“When I tell clients they are getting something completely tax free and Franklin Templeton has made scholarship money available as well, they are on board,” Weyser says. “I tell them about the fees and they are OK with it.”

But each family’s special circumstances figure heavily into college savings decisions., a free online source of financial aid information, finds that when savers have longer to invest, the plan with the lower fees is usually better, whether or not they have access to a state income tax deduction. This is because the value of the deduction is effectively amortized over the life of the account, so the deduction yields very little benefit per year, FinAid says. But if somebody is investing for a high school student, the state tax deduction during this shorter duration “may yield a greater financial benefit,” the site says.

Time horizons also come into play when allocating assets to 529 plans. One strategy is to use age-based funds. Like target-date funds used for retirees, these gradually steer portfolios toward more conservative assets as the investor gets closer to the date he or she will need the money. But the time horizons for college are very different from those of retirement. Children have about 18 years before they have to draw down savings for tuition, while most workers have as much as 40 years before retirement.

Conscious of the distinction, Paul Nikolai, a CFP and principal with Aspiriant, uses a number of options to allocate assets to his children’s college saving plans. Nikolai, who works in the Cincinnati, Ohio, office of San Francisco-based Aspiriant, prefers target-based rather than age-based portfolios. He says Ohio, like a number of states, offers various mutual fund strategies in its offerings, so he can invest his children in international equities, growth stocks, the S&P 500—whatever he feels is appropriate. Ohio’s advisor-directed CollegeAdvantage 529 Plan is managed by BlackRock.

Certainly, 529s aren’t always the best answer for every client. If a 529 distribution isn’t used for tuition or passed on to a sibling, investors can face fines and back taxes. Some clients might want the flexibility in case their children later decide to use the money for something else: to buy a car or make a down payment on a house or business.

“I’ll recommend a [taxable] custodial account when the parent isn’t sure if their child will go to college,” says Amanda Gift, a principal with Signature Financial Management in Norfolk, Va. But when a 529 is the right course, Gift says, she has a number of choices. She finds her own state’s plan, Virginia’s 529 CollegeAmerica plan, has “a decent lineup in terms of performance for all different ages. They have a decent return.”

About 15% of Gift’s clients are using 529 plans, which they find “convenient, like one-stop shopping,” she says. The Virginia plan’s features allow her to manage age-based investments with automatic portfolio rebalancing. The accounts “don’t require as much checking back,” says Gift. On the other hand, the assets are plain vanilla, with nothing too exotic. That keeps risks down, but it may also hold back returns in flat markets.

Another advantage to 529 plans, says Aspiriant’s Nikolai, is that “people can’t market-time in your plan.” Investors can’t withdraw from most 529 funds, which they might want to do when markets are dropping. That means the funds don’t suffer the kind of cash-flow volatility that wreaks havoc on target-date pension funds. When cash flows in and out unexpectedly, portfolio managers must struggle to reallocate resources. It can hurt returns and inflate expenses. “Most college plans have some format so you can’t do market timing with the plan,” Nikolai says.

A final word of caution from the National Conference of State Legislatures: Not all states have managed their college savings plans well. During the economic crisis, Maryland, North Carolina and Virginia saw their 529 accounts lose up to 30% of their value in 2008 alone. In 2012, Virginia responded by creating the College Savings Plan Oversight Act, making its college savings plan subject to a Joint Legislative Audit and Review Commission.

The financial crisis “represented a significant loss for parents whose children were almost ready to attend college,” writes Bautsch in her May 2012 report, “Saving for College: 529 Plans.”

Again, the time horizons are important. With less time to save, the accounts have even less time to recover losses.