Funding Your Kid's Tuition

Can you tell me how to buy a college fund for my child?

QUESTION: Could you tell me how to buy a college fund for my child?

ANSWER: Using mutual funds to save for your child's education can be confusing because of the many variables involved, from tax considerations to future eligibility for financial aid. For starters, though, fund-investing basics, such as proper asset allocation for your time horizon, apply.

"If your kid is still in diapers, you have a pretty long time horizon, so choosing stock funds is a fine approach," says Susan Dziubinski, director of Morningstar University, the fund-tracking firm's online education effort. Depending on your individual risk tolerance, this could be the time to take a relatively aggressive approach, perhaps investing in both large- and small-cap funds with a growth orientation. If your fledgling is entering high school, on the other hand, Dziubinski suggests a more conservative portfolio that leans toward large-cap blue-chip funds, or balanced, growth-and-income or equity-income offerings. For suggested asset-allocation plans — and funds — for different age levels, check out SmartMoney University's College Portfolios.

In general, if the market is healthy, then parents should be prepared to move one year's tuition out of any aggressive funds approximately three years before the child starts college, opting for more conservative portfolios or even money-market funds, says Norman Boone, president of Boone Financial Advisors in San Francisco. That way, you can take advantage of the highs. Meanwhile, "If it looks bad — much like it does now — you have time to wait until the market turns around," says Boone.

Additional questions include what type of mutual-fund account you should open and whether it should be in your child's name or your own. In the child's name, you could open a custodial account to purchase funds under the Uniform Gifts to Minors Act, or UGMA, or the Uniform Transfer to Minors Act, or UTMA, depending on the state in which you live. These accounts provide a place for relatives or generous friends to make gift contributions of as much as $10,000 a year each. Plus, the first $750 of investment income (under 2001 rules) is tax-free for children under age 14, with another $750 taxed at the child's rate, which is usually lower than that of the parents. Any income above $1,500 is taxed at the parents' rate. Once the child reaches 14 years of age, all income is taxed at the child's rate. (For more specifics, see "The Kiddie Tax.")

Keep in mind that accounts held in the child's name may count more heavily against a student seeking financial aid than assets held in the parents' names. Moreover, once the child reaches either 18 or 21 (again, depending on the state), he or she is free to use the money for a meandering trip to Belize rather than Biology 101. Some parents, Boone observes, "are concerned that when Sally grows up, she'll go off with her boyfriend on the back of a motorcycle, strumming a guitar, and skip college."

For these reasons, Boone suggests diversifying among account types. Some parents, he notes, put $10,000 or $15,000 in UGMA or UTMA accounts while keeping the bulk of college savings in their own names. That way, they're able to take advantage of the UGMA/UTMA tax benefits without taking much of a hit from the kiddie tax. But Boone speaks most highly of Section 529 college-savings plans, because these tax-deferred programs, now available in almost all states, allow larger gift contributions at one time and give parents greater control, including the ability to transfer the money — which must be used for education or be subject to penalties — from one sibling to another. "If Sally goes off on the back of a motorcycle," Boone says, "maybe Johnny wants to go to college." The downside is that the funds and other investment vehicles available though 529 plans are limited to those offered by whatever entity the state has selected to run its program, such as Fidelity or TIAA-CREF. Some plans offer investors choices, much like a 401(k), while others permit no choice at all.

Yet another option is an Education IRA. While this kind of account has gotten a bad rap because its annual contribution limit is just $500 — and because eligibility is phased out for higher-earning parents — don't discount it, says Boni Calloway, manager of investor education at Denver-based Invesco Funds. Assuming a 10% annualized return, Calloway says, an investor who placed $500 a year in an Education IRA from the time a child was born would end up with more than $40,000 in 18 years. Drop that return to a more modest 8%, and the figure still reaches $20,000. The bad news, says Calloway, is that "It's probably going to cost you $20,000 for one year at a state school in 18 years." The good news: "At least it would pay for a year."