How to Invest for Your Child
March 06, 2014While we usually discuss investing in the context of retirement planning in 401(k)s and IRAs, I was recently asked by a young mother about investing $50k in her 1 year old child’s name. (Since it’s in the child’s name, the money has to be used for his benefit but since he’s a minor, the mother has control over how the money will be invested and spent on his behalf.) Here are some things to consider.
As with all investment decisions, the first question is what the money would be used for and when it will be needed. In this case, it will be used much later, perhaps for college or to purchase a car when he’s old enough to drive. If the money was to remain in cash, the first $1k of earnings per year would be tax-free and the second $1k would be taxed at the child’s tax rate (assuming the child has no other income) so about 4% a year of earnings would be taxed at a no or low rate. However, any earnings over $2k would be taxed at the mother’s highest marginal income tax rate. That means if the money is invested more aggressively for longer term goals, the gains could end up being taxed at a higher ordinary income tax rate rather than the lower capital gains tax rate for investments held for longer than 12 months.
One way around this is to contribute at least part of it to a 529 savings plan, which grows to be tax-free for qualified education expenses like tuition, fees, and room and board for college, vocational school, or grad school. However, any non-education withdrawals could be subject to ordinary income taxes and a 10% penalty on the earnings so any money earmarked for things like a car would be best left out of the account. (The $2k annual tax protection could be useful for this smaller amount of money.)
Each state has their own 529 plan(s) but you’re not limited to the state you live in or the state where your child goes to school. So which state should you pick? There are 3 things to consider:
State benefits: Many states will provide you with state tax benefits or lower fees for contributing to your own state’s plan.
Investment options: Most plans offer age-based allocations, which are a fully-diversified pre-mix of mutual funds that are designed to be more conservative as your child gets closer to college age. After all, you don’t want to see the value of your college fund plummet if your child happens to attend school in a year like 2008. In this way, they’re similar to target-date retirement funds but arguably even more important since all the money is coming out within a few years, unlike a retirement that could last for 30 years.
Cost: When comparing similar mutual funds, low cost has been shown to be the best predictor of which funds will do better going forward.
So how do you weigh these various factors? Fortunately, consumer advocate Clark Howard has put together a nifty guide to 529 plans. He suggests to go with your state plan if it’s listed on his “Honor Roll” of low cost 529 plans that provide tax benefits or lower fees to residents.
Otherwise, he also has a “Dean’s List” of the very best plans in the country. The lowest cost plans are offered by New York and Illinois but the New York plan lacks international diversification in its age-based allocations and the Illinois plan doesn’t include emerging markets in theirs. Howard’s overall favorite is the 3rd lowest cost plan, the Utah Education Savings Plan, which offers a fully diversified mix of low cost investment options. You can even customize your own age-based allocations using index funds through Vanguard and DFA, the latter of which are usually only available through select investment advisers.
In this case, the mother lives in California, which currently offers no state tax benefits. However, a bill was just proposed in the California legislature to provide a refundable state income tax credit to individuals with incomes of $100k or less on 20% of their contributions (up to $2,500 for a maximum credit of $500) to the California 529 plan, which is listed in Howard’s “Honor Roll.” One option may be to fund the Utah plan now with at least part of the money, leaving out anything to be used for other purchases such as buying a car or making future contributions to the CA plan if the bill passes. Stay tuned…