College Savings Plans With Growth Potential
It’s the start of another school year and a time when many parents worry about how they will be able to afford college for their kids.
Certainly, this is a daunting challenge: Four years at a private university for a freshman enrolling a decade from now is expected to cost about $134,000, according to the College Board; the estimate is $61,000 for four years at a public school. Student aid can help meet these expenses, and so might a rich aunt. But most parents will have to depend on their own finances to a large extent, and that’s where mutual funds can help.
Fund companies make it easy to embark on any long-term investment plan, whether for college, retirement or other goals. Most require only $1,000 to $2,000 to get started, sometimes less. You can then put away much smaller chunks of $25 to $100 a month.
You may elect to have the money transferred automatically from a bank account to the fund of your choice, eliminating the need of writing a check each time. “The real key of college planning is to start early, preferably when the child is born,” says Esther Berger, a stockbroker with Paine Webber in Beverly Hills. “Make it a fixed expense, a commitment from the get-go.”
Stock mutual funds offer the long-term appreciation potential that you will probably need to keep up with education costs, which have exceeded the general inflation rate for many years. “If your investment has to grow by a large amount, you have to be more aggressive,” says Mark A. Hoppe, president of Buffalo Capital Management, an investment advisory firm in Newport Beach.
With bonds, after you pay taxes on the interest income and any capital gains, you can only expect to roughly break even with inflation, based on 65 years of performance results compiled by Ibbotson Associates of Chicago. With money market funds, certificates of deposit and similar “cash” holdings, you will likely lose purchasing power after having to pay taxes. Only stocks and equity funds have shown an ability to move upstream over time against the double currents of inflation and taxation.
While you should probably make stocks or equity funds the backbone of your college plan, especially for younger kids, you can also mix in some fixed-income products. For example, Berger recommends an even split between equity funds and high-quality bonds or bond funds.
She particularly likes individual zero-coupon bonds for college-planning purposes. Zeros don’t make periodic interest payments as regular bonds do but instead are sold at a discount to their maturity value; you would earn a return as that price gap gradually closes over time. For example, a U.S. Treasury zero coming due in 10 years sells for about $450 for every $1,000 in maturity value, offering a compounded yield of roughly 8.1%.
Since zeros mature at a predetermined value on a specific future date, you can buy one that will come due in the year your child enters college. “A lot of people like to know, psychologically, that the bonds will be worth a certain amount on a certain date,” Berger says. Unfortunately, at current rates zeros don’t yield enough to provide any chance for exceptional growth. Another drawback: You will still owe taxes on zero bonds (except for municipal issues) even though you don’t receive interest payments.
Even so, zeros offer an anchor of security for a stock portfolio. You can buy individual zeros through a brokerage. A handful of no-load companies--Benham Capital Management (800-4-SAFETY), Scudder (800-225-2470) and United Services (800-873-8637)--offer zero-coupon funds. These portfolios hold bonds coming due in a single year and thus liquidate at a predetermined price on a specific date.
In addition to these choices, a couple of mutual fund companies have unique products designed for college savers.
Under a plan offered by 20th Century Investors (800- 345-2021), your money initially goes into a blue chip stock fund, then gradually gets transferred to a money market portfolio. The idea is to start out aggressively when your child is young, then switch to a more conservative stance as the date nears when you will need the cash. You may choose from among three basic schedules for transferring money between the two funds. You can get started with monthly contributions of $25 or greater. There are no sales charges on 20th Century products.
Fidelity Investments (800-544-8888) has a college savings plan in which you can choose from among four funds--two stock, one asset allocation and one money market--all on a no-load basis. You need $1,000 to get started, with $100 or more in subsequent contributions.
The Fidelity program requires you to establish a custodial account under the Uniform Transfers to Minors Act. This is an arrangement under which your child gains control of the money at the age of majority. Custodial accounts, which can be set up at most financial institutions, have a nice tax-sheltering benefit. If your child is 14 or younger, the first $550 in investment income is tax free, while the next $550 is taxed at his or her (presumably) lower rate. For an older child, all income is taxed at his or her rate.
Also worth considering is a free college-planning guide available from T. Rowe Price Associates (800-638-5660), a Baltimore-based fund group. The package contains a work sheet to help you calculate how much you will need to put away now or in increments to afford college by the time your child is ready to enroll.
Why Mutual Funds?You can build a college account using virtually any type of savings or investment vehicle, yet mutual funds offer a particularly good choice.
Here are some reasons:
* Low minimums: With most funds, you can get started with an initial investment of $1,000 to $2,000, sometimes less. Later, you can add to your cache in increments of $25 to $100 or so.
* Automatic investing: Many companies allow you to have money transferred each month from your bank account into the fund of your choice.
* Investment flexibility: Most fund companies will let you switch from one type of fund to another, usually with a phone call. For purposes of financing education costs, you might want to start out with a stock fund and transfer to a money market portfolio as your child nears college age.
* Diversification: Compared to individual securities, mutual funds tend to move fairly closely in line with the broad stock or bond markets. Thus, there’s less chance of disastrous losses for long-term college investors.
* Growth potential: Based on historic performance, stock mutual funds offer a much greater chance for appreciation than do bonds, bank accounts and other traditional savings vehicles.
* Tax shelter: You can hold most funds inside a custodian account. This lets you partially or wholly shelter up to $1,100 in investment income for kids 14 and younger and larger amounts for older children.
