First, should I be investing these funds in a Section 529 plan for his college education, or should part go to a Section 529 and another part to a "regular" sort of fund?If, in fact, I am to put funds in a regular fund, I am seeking some suggestions as to names of funds that might be appropriate given my son's age. I am invested in funds such as Longleaf Partners, Clipper, Bridgeway, Oakmark, and Dodge & Cox. But I'm not sure these are the sort of fund I should be considering for him, even though I love the way these funds are managed and the returns they have been accumulating. This could turn out to be quite a little nest egg for him in the future. David N.
First, let me applaud your decision to begin investing your child's Social Security income. It would be hard to imagine a better way to honor the memory of your wife than to put that money to work in a way that brightens your son’s future.
Your question touched on the two key decisions confronting most parents looking to save on behalf of their children: first, whether to save in a regular old taxable account versus a tax-sheltered college-savings vehicle (such as a 529 plan), and second, identifying the right investments given your child's time horizon.Gimme Shelter?
Let's start with your first decision: whether to opt for a 529 plan or invest in a taxable account. (I'll focus largely on 529 plans for this article, but parents should know that such plans are just one of several ways to invest for college. My colleague Sue Stevens provided an excellent overview of the pros and cons associated with each type of college-funding vehicle in a recent article
Of course, stashing your son's assets in a taxable account probably appeals to you because of the flexibility it affords. By saving in a taxable account, you’re spared from having to deal with the limitations and rules that tax-sheltered plans might impose. Investing in a taxable account also gives you full run of the mutual fund universe. Not so with a 529 plan, which is typically managed by a single fund company and may be limited to a handful of investment options. (Goodbye Oakmark and Clipper; hello Vanguard, Fidelity, and T. Rowe Price.) Finally, because you don’t have to specifically earmark the savings in a taxable account for college expenses, you retain the freedom to use the money for anything that your son needs.
Those are legitimate issues. So let’s consider them one at a time, starting with the limitations that a 529 plan might impose on investments you’re making on your son’s behalf. As a matter of fact, 529 plans allow for very generous contributions over the life of an account. Contribution limits vary with each state's plan, but some 529 plans allow investors to sock away upwards of $300,000 for a single beneficiary--a big selling point given the dizzying escalation in college costs over the past several years.
As for a 529 plan limiting your investment options, there’s no doubt about that. But if you’re looking to maximize your college-savings dollars, I think that limited choice is a reasonable price to pay once you consider the benefits you’re accruing. Namely, not only will your son’s investment earnings grow on a tax-deferred basis in a 529 plan, but when he is ready to go to college, withdrawals from the plan will be tax-free provided he uses the money to pay for college expenses (tuition, room and board, and books all count.) Put another way, no matter how good the choices are in your taxable account or how deftly you choose from that menu of options, you’ll still be hard-pressed to match the returns that you get in a 529 plan due to benefits that tax-free compounding and withdrawal confer.
Furthermore, your 529 plan investment choices might not be quite as paltry as you think. In fact, the key
to successful 529 plan investing is to be choosy--look beyond your own state's plan if you find it lacking. Although some states offer tax breaks or other goodies for those who opt for the in-state 529 plan (and a few, such as Illinois
, actually penalize
you for opting for another state's plan), you're otherwise free to choose the plan that best suits your needs and investment preferences. For the second year in a row, Morningstar recently named the Utah 529 plan its top choice for do-it-yourself (i.e., no-load) investors. Not only does Utah field a solid lineup of low-cost Vanguard funds, but the state further cuts down on the plan's overall cost load by administering the plan itself. If you're a fan of active management (and it sounds like you are), you'll want to check out the Alaska plan, which includes a number of topnotch actively managed funds from T. Rowe Price. So, while the pickings in the 529 world are bound to look slimmer than the cornucopia of options you’d have to choose from in a taxable account, it’s not a feast-or-famine proposition.
Finally, while there’s surely value to having the freedom to disburse funds from a taxable account in any manner you see fit, using a 529 plan imposes a healthy amount of discipline on the college-savings process. Although you can withdraw 529 assets at any time and for any reason, you have a strong disincentive to do so: You'll generally pay a 10% penalty and income taxes on your earnings if you don't use the money to pay for qualifying college expenses. (You may also have to repay any state-tax benefits you gained from investing in the 529.)Time Horizons and the Younger Set
Now for the second part of your question: What types of investments make the most sense for a young person like your son? (If you do opt for a 529 plan, you'll find that it's still up to you to allocate your investment dollars among the plan's various investment options.) First, you'll want to turn your attention toward arriving at an appropriate stock/bond mix for your son's assets. Given that he has nearly 10 years until he matriculates, you'll surely want to keep the majority of his money in stock funds, but I'd recommend that you turn to the Morningstar Asset Allocator
tool for more specific guidance about how to divide his assets among stocks and bonds, large caps and small caps, and international and U.S. stocks. (Asset Allocator is free to Premium Members of Morningstar.com; for a free trial, please click here
As I noted earlier, 529 plans aren't apt to feature any of the specific funds you mentioned as your favorites. But that shouldn't stop you from looking for investments run by managers whose investment philosophy you respect and believe in. Some financial planners might lean heavily on growth-oriented funds when assembling portfolios for young people, with the thought that youngsters have the long time horizon needed to ride out the volatility inherent in such offerings. But there's no reason you shouldn't put the lion's share of assets in value-oriented investments like the ones you seem to favor. If you believe in a fund's strategy, I think you're much more likely to have a good ownership experience with it--having the confidence to hang on if its returns hit a rough patch, for example.
Alternatively, parents who are less enthused about identifying and monitoring specific investments for their children's college-savings plans might consider a target-maturity fund that's specifically designed to shift into more conservative investments as a specific target date, such as college enrollment, draws near. (I discussed these funds in a recent column
.) In a similar vein, many 529 plans offer "age-based" investment options, which are designed to grow more conservative as college draws near.