Funds May Make Sense to Pay for College

Considering the high costs of college these days, you might consider it futile even to attempt to put away money for your child’s higher education.

But if you’re still willing, consider placing mutual funds at the core of your portfolio.

U.S. Savings Bonds, bank certificates of deposit, stocks, bonds and insurance products all can be used to foot a child’s future education bill.

If your child will be entering college within a few years, you might have little choice but to use some of the safer vehicles around, since losses at this late stage could be disastrous.

But assuming you have a longer investment horizon of at least four or five years, mutual funds are the vehicles of choice. For versatility, ease of access, growth potential and other advantages, few challengers can match them.

“Mutual funds usually fit like a glove, especially stock funds,� says Dave Adler of John Hancock Financial Services in Tucson, Ariz.

Consider how funds stack up against Series EE U.S. Savings Bonds. These are default-proof obligations of the federal government. Holders earn tax-deferred interest until the bonds are redeemed.

If the proceeds are used for college tuition and fees, the income generated can be permanently free of tax. (This break phases out for people with higher income.) And savings bonds can be purchased for as little as $50 or less.

Sounds good, right? The problem is that savings bond yields aren’t going to make anyone rich, even on a tax-free basis. The minimum guaranteed rate on bonds redeemed within five years of purchase was recently cut to 4% from 6%.

Reflecting this change, savings bond sales tumbled 33% in July from their year-earlier levels.

Bond buyers who hold them at least five years are likely to earn higher, market-based interest rates. But if you’re willing to stay put that long, you might as well go with a stock mutual fund, because of the much greater growth potential.

With the exception of municipal bond portfolios, mutual funds don’t offer tax-free interest like savings bonds do, unless, of course, the funds are put into a tax-sheltered retirement plan.

But remember, you might not need much in the way of tax savings for assets placed in your child’s name.

For kids under age 14, the first $600 of investment or savings income avoids taxation, and the next $600 is taxed at a special rate, most likely 15%. For an older minor, all investment income would be taxed at his or her personal rate, not that of the parents.

So for a child under 14, you could sock away roughly $60,000 in stock funds yielding 2% in dividend income before having to worry about paying taxes at higher rates.

Any capital gains would be subject to taxes, of course, but over time the net appreciation on stock funds should still enable them to outperform savings bonds.

Because of their greater growth potential, stock mutual funds are also usually a better bet for the long haul than other fixed-income investments, including certificates of deposit and zero-coupon Treasury and municipal bonds.

Traditionally, zero-coupon bonds have been a popular way to plan for college since the bonds are sold at deep discounts off their ultimate maturity values.

But the size of the discount reflects the general level of interest rates, and these days the rates aren’t compelling.

The same can be said for most other types of bond investments. High and escalating college costs may demand that you strive for greater appreciation potential.

“You almost have to use growth investments to send kids to school,� says Thomas J. Connelly of Keats, Connelly & Associates, a Phoenix financial planning firm.

A portfolio of individual stocks can be expected to provide good long-term appreciation, although stock mutual funds will often represent a better alternative.

Why? Because mutual funds feature professional management and diversification at a much lower cost than you can get with individual stocks.

Also, funds allow for more efficient reinvesting of dividends and capital gains into new shares--a factor that can boost returns over time.

Besides, funds are a much easier and safer way to access certain types of stocks, such as small companies and foreign equities.

Various insurance products now offer mutual fund-like investments and may be worth a look.

In particular, you might find variable life appealing for college planning, as it provides tax-deferred compounding while allowing penalty-free loans.

In addition, many variable-life policies offer attractive portfolios in which to invest, including those with good stock market exposure.

Furthermore, “there’s an insurance policy backing it all up, so if the parent dies, the kid can still go to college,� notes Jennifer Strickland, editor of the Morningstar Variable Annuity/Life Performance Report in Chicago.

But what investors need to realize is that variable-life products are more complicated than mutual funds and are rarely sold on a commission-free basis.

“They’re pretty complicated--most people would want help figuring one out,� says Strickland.

They’re also less enticing if you already have ample life insurance in place.

And keep in mind that if you take out large loans against these policies and the stock market crashes, pulling down the remaining value of your account, you might have to pony up more money just to keep the insurance in force.

This would be an unwelcome development, especially if the insurance component is only a secondary consideration in your college planning effort.

Mutual Funds for the Tuition Tab Here are eight reasons why mutual funds, and especially stock funds, are appropriate for college planning.

* Professional management. Harried parents do not have to worry about buying and selling individual securities themselves.

* Security diversification. With dozens or scores of holdings, most funds will track their respective markets fairly closely over time--a comfort for parents with a long-term investment outlook. There is little danger that an individual holding will bring an entire fund down with it.

* Asset diversification. Mutual funds are the most efficient way to get low-cost access to various types of asset categories, from large foreign stocks to small U.S. companies. College-oriented investors may want to spread their money among different types of stock funds.

* Switch privileges. Most fund families allow easy, no-cost exchanges between funds. As children approach college age, parents might want to switch from riskier stock funds to safer bond or money-market alternatives.

* Low minimums. Most funds can be purchased with initial investments of $250 to $2,500, allowing nearly all cash-strapped parents to get started.

* Dollar-cost averaging. Many funds will let you set up systematic investment programs that allow monthly contributions of as little as $25 or $50. With or without this feature, nearly all funds allow subsequent investments at any time.

* Liquidity. Nearly all funds will let investors pull out money at any time. Many fixed-income portfolios feature check-writing privileges for ease of access--a handy feature when it comes time to pay college bills. Some fund companies have systematic withdrawal plans for removing money at regular intervals.

* Ease of reinvestment. Mutual funds allow any amount of capital gains and dividends to be reinvested in additional shares automatically--a feature that can boost returns over time. This convenience typically is not available with individual stocks and bonds.