This Season, Give a Mutual Fund

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What are my options for opening a mutual-fund account for my newborn niece? How much can I give her each year?

QUESTION: I would like to know what my options are for opening a mutual-fund account for my newborn niece. I don't want to buy her a bond like everyone else. Is there a limit to how much I can give her in a year? If I open an account, should I put it in trust for tax purposes?

ANSWER: Investments make terrific gifts for children — after all, kids come with lots of expenses, especially if they plan to attend college. Plus, a fund investment will last a whole lot longer than bunny pajamas from Baby Gap. "Teddy bears are cute, but gifts like this keep on giving for years to come," says Kevin McKinley, a certified financial planner based in Eau Claire, Wis. And if you're considering this account as a Hanukkah or Christmas present, the best time to start is now, since you have some paperwork ahead of you.

First, you'll need to decide how you'd like the money to eventually be used, and how much control you want to have over how it's invested. If you'd like the money to be applied to your niece's college tuition or related purchases, perhaps the best option is a qualified state tuition plan, also known as a 529 plan. With a 529, you open the account under your name, citing your niece as the beneficiary. Then, your money grows tax-deferred (and tax-free starting in 2002) for qualified withdrawals. You can contribute up to $50,000 in one year ($100,000 for a married couple), to be applied over five years, without exceeding the $10,000 annual limit on tax-free gifts. "Best of all, you keep total control over the account," says McKinley. "If your niece doesn't go to college, you can change the beneficiary to another member of the family."

Your investment choices will be somewhat restricted with one of these plans, however. Most 529 plans offer a limited number of mutual funds from a single fund family. Fortunately, many plans allow out-of-state residents to invest, so you can shop around if your state's offerings don't suit you.

For a gift with a broader purpose, try an Education IRA, also known as a Coverdell Education Savings Account. Opened in a child's name, it must also be applied toward educational purposes, but can be used for primary- and secondary-school expenses such as private-school tuition. You can buy any mutual fund in an Education IRA, though contributions are currently limited to $500 annually. (That level will rise to $2,000 next year.) Withdrawals for qualified expenses are tax-free, but keep in mind that you're not eligible to open one of these accounts if your income exceeds $110,000 for single filers or $160,000 for joint filers (though the ceiling for joint filers will increase to $220,000 in 2002). For more on this, see our story.

You can also buy mutual funds in a simple custodial account under the Uniform Gifts to Minors Act, or UGMA, or Uniform Transfers to Minors Act, or UTMA, depending on your state of residence. You or one of the child's parents must be designated as the account's guardian, but the child owns the account once he or she reaches legal age, usually 18 or 21, depending on the state. Keep in mind that your money may be used for purposes that you didn't have in mind. "If the child is rebellious and at age 19 wants to buy a car, technically he or she could do that," says Sue Stevens, Morningstar's director of financial planning.

If you want more control than that, you should consider opening a traditional trust. For example, you may want not want the child to have access to the money until age 25 — above the legal age in any U.S. state. You also can specify how the money should be spent, such as on the purchase of a first home. "If control is an issue — and it is in some families — this might be the way to go," Stevens says. This is the most expensive option, however, since you'll need an attorney to establish the trust for you. "Unless the value of the account is expected to be at least $10,000, the cost and hassle of setting up a trust just aren't worth it," says McKinley.

A less formal option is simply to open a regular mutual-fund account in your name or one of the parent's names and decide that the money will be used for the child's benefit. This could be a good solution if the child is likely to apply for financial aid someday, since colleges usually weigh a child's income more heavily than that of the parents. However, if you're planning to purchase a fund this way before the end of the year, make sure that the portfolio has already made its capital-gains distribution — if any — for 2001. Remember, too, that the person in whose name the account is registered will be responsible for any taxes.

And as your niece gets older and develops an understanding of money, you may want to buy her shares in one of the mutual funds that come with educational materials, such as the Stein Roe Young Investor fund (SRYIX). (By the way, Dec. 31 is the deadline for the Stein Roe national essay contest for children in grades five through 12.) Other options include the USAA First Start Growth fund (UFSGX) and Monetta Funds' children's investment program. Unfortunately, these funds don't boast great short-term records, but for a child with a super-long investment horizon, they should be fine.