Image: Graduation cap © Stephen Wisbauer, Getty Images

State-run 529 college savings plans are getting better.

They're reducing fees, improving investment options and reporting better performance. These programs, which allow parents and others to invest in tax-free accounts to pay for college, are benefiting from closer supervision by many of the states, which are negotiating better terms with the investment companies that administer them. For the first time, no plan wound up in Morningstar's "bottom" rank in the research company's most recent review.

"The days of really stinky investments embedded in 529s are over," said Laura Pavlenko Lutton, the editorial director for Morningstar. "The industry's really improving."

That said, there remain big differences among the plans, particularly when it comes to fees. The most expensive plans (Kansas' adviser-sold version of LearningQuest, New Jersey's Franklin Templeton 529 College Savings Plan and Alaska's John Hancock Freedom 529) cost investors seven times more than the cheapest plans (the Utah Educational Savings Plan and New York's 529 College Savings Program).

Costs matter -- a lot. The more expensive an investment is, the less likely it is to outperform over the long run, Morningstar analysis has shown. In the 529 world, high fees were often coupled with poor performance, as some high-cost program administrators larded their plans with "weak sister" funds that trailed their peers.

Residents of states that offered tax breaks for 529 contributions once had to hold their noses and invest in bad plans. That's because a state tax break was assumed to be big enough to offset a plan's downsides. That's because the tax break was usually assumed to be big enough to offset the plan's downsides.

Liz Weston

Liz Weston

Today, everyone has better options available, but you have to know what they are if you want to take advantage. Here's what you need to know.

Start with your tax situation

Whether or not you get a tax incentive helps determine where you should invest:

  • Most states that tax incomes offer some kind of tax incentive for investing in a 529 plan. (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming have no state income taxes and therefore no tax break.)
  • The exceptions to the rule are California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Hampshire, New Jersey and Tennessee, all of which have a state income tax but none of which offer a tax break. (New Hampshire and Tennessee tax only dividend and interest income.)
  • Residents of three states -- Kansas, Missouri and Pennsylvania -- get a tax break if they invest in any state's plan. The other states with tax breaks require residents to stick with their in-state plans.
  • Most states with tax breaks allow residents to deduct their contributions, up to certain limits, from their taxable income. (You can see details of each state's tax break here.) Three states -- Indiana, Utah and Vermont -- offer tax credits, which directly reduce tax bills. Indiana's is the most generous tax benefit by far: Residents get an annual credit worth 20% of the first $5,000 of 529 contributions, which allows them to subtract up to $1,000 from their state tax bills

No reason to stay put? Go for the best

If your state doesn't give you a tax incentive or doesn't require you to invest in your own state's plan to get it, then you might as well invest in one of Morningstar's top-rated plans that are sold directly to investors (rather than through an adviser). These include:

  • Alaska's T. Rowe Price College Savings Plan and the Maryland College Investment Plan. These are good choices for investors who want active management and are willing to be more aggressive. Both of these T. Rowe plans "are built upon a chassis of well-executed funds," Morningstar says, but it notes that expense ratios are higher and that the aged-based options' asset allocations are heavier on equities than are other direct-sold plans, which rely more on index funds.
  • Ohio's CollegeAdvantage 529 Savings Plan. Morningstar says "there's something for everyone" in a plan that offers managers Vanguard, Pimco, Oppenheimer and General Electric. You can find such variety elsewhere, but this plan distinguishes itself with low fees.
  • Nevada's Vanguard 529 College Savings Plan. This is the go-to plan for those of us who eschew active management in favor of index funds at low, low cost. The plan requires a $3,000 initial contribution; if you don't have that handy, consider Utah's plan.
  • The Utah Educational Savings Plan. Again, Vanguard index funds, and now with new, lower prices. Plus, there's more control as an investor, if you want it: "The plan's new set-it-once asset-allocation tool allows savers to dictate a mix of investments to change every year as a child nears college," Morningstar notes. "Not every saver needs that extra capability, however, and the plan's other options are solid."
  • Another plan made Morningstar's list of top programs: Virginia's CollegeAmerica 529 Savings Plan. This fund is sold only through advisers and is the country's largest plan, with nearly $30 billion in assets. I think most investors are better off in direct-sold plans, but if you're using a financial adviser, you'll probably do best in this low-cost plan that "features high-quality investments run by risk-aware, proven investors," according to Morningstar.


Getting a tax break? Avoid the worst

If your state does give you a tax break to stay put, avoid the plans that wound up on Morningstar's "below average" list:

  • Wisconsin's adviser-sold Tomorrow's Scholar College Savings Plan, administered by Wells Fargo, suffers from "unremarkable investment choices," Morningstar says. Residents who want to keep their tax breaks (they can exclude up to $3,000 annually from their income) have a better option: They can invest in the state's EdVest College Savings Plan, also run by Wells Fargo, which received Morningstar's "average" rating.
  • Maine's NextGen College Investing Plan "features a pricey lineup of investment options," according to Morningstar. Its program manager, Merrill Lynch, was fined by regulators for its sales practices. Mainers get a $500 grant for opening a NextGen account before their child's first birthday, while some residents with older children can get a one-time matching grant of $200, and up to $400 in additional matching grants may be available for any beneficiary. After that, though, there's not much reason to stay: Residents can deduct $250 per child from their taxable income for contributions to any state's plan. Beneficiaries can have plans in more than one state, so rather than closing NextGen accounts and losing the grants, residents can simply open new accounts elsewhere.
  • Nebraska's TD Ameritrade 529 College Savings Plan is hampered by high fees. Morningstar says "a disappointing price tag" diminishes the appeal of this plan. A better choice for Nebraska residents who want to keep their $5,000 income exclusion would be the state's NEST Direct College Savings Plan.
  • Rhode Island's CollegeBoundfund was ranked "bottom" for its high costs and weak stewardship by administrator AllianceBernstein until the plan added Vanguard indexed investment options. Since Rhode Island residents don't have other program choices, if they want to keep their tax breaks (up to $1,000 excluded from income), they should stick to the Vanguard choices.
  • Kansas' Schwab 529 College Savings Plan has the highest fees of any direct-sold plan, Morningstar notes, and its administrator has suffered from executive turnover and regulatory run-ins. Fortunately, the Kansas tax break (up to $6,000 excluded from income) is portable, so residents can invest in any state's plan. Also, Kansas offers another direct-sold plan that Morningstar rated "above average": the LearningQuest 529 Program (Morningstar didn't rate the higher-cost, adviser-sold version).
  • Minnesota's College Savings Plan, administered by TIAA-CREF, is hampered by high fees, but since residents don't get tax breaks (and since the state eliminated the matching grants that once provided an incentive to stay), they're free to go elsewhere.
  • A seventh program that made the below-average list, Nevada's Upromise College Fund 529 Plan, is unusual in that it's tied to a rewards program. People register their credit cards with the program and get rewards from their purchases in the form of money invested in this plan. Unfortunately, fees that are roughly double what similar programs elsewhere charge make the program "a poor value proposition," in Morningstar's words. If you've already got an account, you may just figure you're getting free money, so the fees don't matter as much. But think twice about investing more in the plan.

Finally, a word about adviser-sold funds

About half the money in 529 plans these days was placed there by financial advisers. My hat is off to any adviser who convinces a client to invest for a child's future college education, because that's such an important goal. I don't, however, think it makes sense for investors to pay big sales loads and high continuing expenses for the privilege -- especially if the clients are simply placed into age-weighted options, where all the heavy lifting, from asset selection to rebalancing over time, is done by the fund rather than by the adviser.

Click here to become a fan of MSN Money on Facebook

If you are investing through an adviser, take a close look at what you're paying in fees and continuing costs. See whether the performance you're getting, compared with similar options in the top-rated funds, offsets those expenses. I'll venture that it probably doesn't and that you'd be better off in a less-expensive, direct-sold plan. At the very least, ask your adviser why you're not using Virginia's plan.

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.