How to Invest For College
By David Wolpe ([email protected])
November 19, 1997

In recent weeks, we've taken a look at investing from a child's perspective by asking a variation on the old Watergate question: What should a child know and when should he know it? We now turn with a shudder to confront ourselves as parents. Whether our child is an Einstein or an epsilon, whether he's 10 weeks old or 10 years old, we as parents should be setting aside money, if we can, for him. What's the best way?

Among the financial goals that a parent has for a child, one seems to tower above all others: providing for a college education. With tuition currently topping $20,000 a year for some of the top private schools, and with projections of future college costs reaching into the hundreds of thousands, it's more necessary than ever. TMF Hoyden's excellent series of articles on How To Pay For School looked at ways to reduce the expense. Now we're going to look at meeting it.

What Will College Cost?

The benefits of a college education, both financial and otherwise, far outweigh the costs. What exactly will those costs be? No one knows for sure, but we can make an educated guess if we know the current costs, the amount of the initial investment, the investment return, and a reasonable inflation rate.

Let's say, for instance, that you have a 3-year-old, and you want to plan for her college education, which will begin in fifteen years. Here are two scenarios using a fairly aggressive rate of return on your investments:

1. Private School
Current Cost per year -- $20,000
Years Until College -- 15
Annual Inflation Rate of College Expenses -- 5%
Expected Rate of Return on Investments -- 20%
Initial Investment -- $2,000
Amount you can invest monthly -- $150

Expected cost of tuition in 15 years: $41,579 per year, or a total of $166,314 for four years.

How much money you'll have, based on the above investment assumptions: $174,122.

In other words, you'll have about $8,000 left over for books, kegs of beer, and the down payment on her new hovercraft.

Here's a second scenario:

2. State School
Current Cost per year -- $9,000
Years Until College -- 15
Annual Inflation Rate of College Expenses -- 5%
Expected Rate of Return on Investments -- 20%
Initial Investment -- $1,000
Amount you can invest monthly -- $50

Expected cost of tuition in 15 years: $18,710 per year, or a total of $74,841 for four years.

How much money you'll have, based on the above investment assumptions: $75,321.

In other words, you'll only have a few hundred bucks for the kid to blow on pizza.

Now, keep in mind that both of these scenarios require 20% annual returns. Although the Foolish Four variation of the Dow Dividend Approach has generated more than 20% average annual returns over the past 36 years, this performance is nearly double the stock market's average and does not include tax consequences.

For the purposes of this article, we might just as well say that however much money is needed, it's "a heck of a lot." A decade and a half hence, when your confident, good-looking, humorous, good-natured, tough-yet-compassionate, popular-yet-inwardly-secure, artistic-yet-business-savvy 18-year-old pushes open the glass door of her dormitory, you want to be wiping a tear from your eye because you're proud, not because you're broke. What's the most effective way to save for that moment?

In Trust We Trust?

Questions that parents ask themselves: "If I am going to invest in a fund designed for children, then should I open a special account in my child's name or should I simply invest using my own account and, when the time comes, pay for my child's education from my own funds? Are there mutual funds that provide substantial benefits and simplicity of use, combined with market-beating returns and substantial tax savings?" Let's take a look at two of the better-known mutual funds aimed at children and parents.

American Century-20th Century Giftrust

We called American Century and were told that this fund sets up an irrevocable trust, with a minimum maturity of ten years. This means that money can't be taken out before then. The person who grants the account (the parent, in this case) is the grantor. Taxes are paid out of the account, and only the grantor can make contributions. The first $1600 of income per year (from dividends and capital gains) is taxed at 15%; over $1600 is taxed at 28%. When you give the money to your child, it's counted against the tax-free $600,000 that you're allowed to give your child out of a trust when you kick off toward that Eternal Long-Term Market in the Sky.

Let's assume (for purposes of comparison, below) that in each year you earn $1300 in income from this fund, and that your personal income tax level is 30%. The tax paid on that $1300 is 15%, or $195. Had it been taxed at your personal rate, you'd pay double (30%), or $390. So you've saved $195 a year in taxes.

Stein Roe Young Investor Fund

Next we contacted Stein Roe by telephone. This fund, according to its Fund Objective statement, seeks "long-term capital appreciation while providing young investors with an educational introduction to investing." It does the latter in a couple of ways: educational material is sent, starting with a comic/activity book. A quarterly newsletter details one of the stocks in the fund and talks about investing in general. It's written to about a 5th- or 6th-grade reading level. And it invests in companies -- such as Intel, Mattel, Wrigley, AT&T -- that might affect the lives of children. Interestingly, the current top holding of the fund is Intel, comprising 2.1% of the fund. It is interesting because this is one of the criticisms that we at the Fool raise about mutual funds in general. It is difficult, when one has to make up a fund of so many stocks, to have a great many investment ideas.

We asked if there were tax advantages. The phone salesperson replied that there are, indeed, if you set it up as a custodial account. If your child is under the age of 14, the first $650 of unearned income is tax-free. The fund pays dividends and capital gains, from buying some stocks over the course of the year and selling others, which must be reported as income each year. Assuming the same $1300 annual income from the fund examined above, the next $650 is taxed at the minor's tax rate, which is generally 15%. (For a fuller explanation of custodial accounts and the kiddie tax, take a look at TMF Taxes's clear descriptions in his Tax Strategy collection.)

What's important to keep in mind here is that this fund is not inherently different from other mutual funds. Its appeal is that it sends your child a booklet that may have interesting information about investing, and that it tries to invest in stocks that may be of interest to kids. But its "tax advantage" applies only if you set it up as a custodial account, and that's something you can do for your child with any mutual fund. (Again, for more information on taxes, see our Tax Strategy area.)

Are these tax advantages worth it? Suppose we earn $1300 in a given year. The first $650 is tax-free. The second $650 is taxed at 15%, making a total of $97.50 paid in taxes. If we assume that the parent is in a 30% tax bracket, the parent would have paid 30% of $1300, or $390. Each year, you save $292.50. Over the course of 15 years, you've saved $4,387.50. Not bad. It beats the 15 x $195, or $2925, that you'd have saved with the Giftrust fund.

But wait.

Honey, I Shrunk the Savings!

Let's go back to our college cost calculations. We've assumed 20% returns and a monthly addition of $150, which grew our initial $2,000 to $174,122. But what if the returns are lower? What if they're, say, 10.8% (which is about the market average)? Your $2,000 then grows to $78,582. Yikes! That's $95,540 less! So even if you had saved $4,387.50 in taxes by using the Stein Roe custodial account, you'd have been much better off investing in a strategy that generates higher returns over the long term.

When you factor in the fact that about 80% of mutual funds underperform the market, the bottom line becomes clear: the most critical factor in long-term investing is the rate of return.

This means that we are on happy and familiar ground: The Motley Fool's feelings about the best way to invest. If you're investing in an index fund, you're going to match the market returns, which have been around 11% historically. If you invest in the Dow Approach or the Fool Four, you're looking at average annual returns that have averaged over 20% since 1971. If you invest in growth stocks that don't pay dividends, you don't pay any taxes over the years, and if you've chosen great long-term companies then there's no need to sell for at least five or ten years. If you've created a custodial account, and the child waits until after she's 14 (when the kiddie tax goes away), she can liquidate up to $4,000 per year for the next 10 years or so without having to pay taxes on it. This gives the child about $40k in tax-free money.

In the end, investing for your child's education is not much different from investing for your retirement. You can -- and should -- take advantage of tax breaks, but you need not be tied to a given fund if you don't think it will outperform the market. If you can find some great long-term growth stocks to put your money in, and you can keep it there, so much the better.

[See what Foolish parents are saying, and post your own thoughts, on the Family Fool message board.]

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