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Saving for College

Chris Farrell Apr 22, 2008

Question: On average, we save about $1000 a month. $500 of it goes to a 529 college savings plan for our son (he’s about two years old). $200 goes to two Vanguard index funds (Total Stock Market and Total International) in our regular taxable account. And we put $300 in a money market fund with our bank.

The money market is now at about $7000, and we realize we don’t have a good option to invest that money. We don’t want to have the money sit in a money market account. Certainly not for 16 more years. Neither do I feel comfortable putting all of it in 529. Hence, I am looking for an option that (1) provides growth opportunities, (2) has low tax impact, and (3) has some mechanisms built in for age-appropriate auto-(re)balance.

In the last show, Chris mentioned tax-managed mutual funds as an option for semi-long term tax efficient investment. I looked at Vanguard’s tax-managed funds. They all cost quite a bit to start, $10,000. So this doesn’t seem to be a valid option.

What other options are available? I suppose that I can buy ETFs at a discount on-line brokerage as a way to boost tax efficiency and hold diversified investment stocks. I am not sure if, given the amount of dollars we are talking about here, ETF would be a good choice, e.g. the amount of saving on tax efficiency would offset other shortcomings of ETFs. I have a hard time thinking about or comparing ETFs with index funds. In addition, I will have to do age-appropriate asset re-allocation myself with the ETF funds. Because that would take time and discipline, it might not be an attractive option 10 or 15 years from now.

Another thought is to buy a Vanguard target retirement fund that sets my son’s college entrance year as the retirement target year, say 2020. With this, I at least can have stochastic asset reallocation as a means to reduce portfolio risks. But I have no idea how tax efficient that fund is. And it probably is not. Thanks. Key, Cary, NC

Answer: Your question is extremely thoughtful, and just reading how you’re thinking through the various options and trade-offs might help someone else decide what to do.

Fact is, I like what you’re doing: a mix of a 529 plan, index funds and a money market fund. I hope that the index funds and money market fund are in your name so that if your son gets scholarship money, you can tap the savings for your retirement. I prefer the index mutual funds over ETFs because the former are ideal for adding money on a monthly or quarterly basis without paying the brokerage fees or commissions. So I would take some of the money market fund money and put it to work in the index funds.

One other thought: You could buy some I-bonds to add into the mix. The fixed 30-year rate of interest on the inflation-protected savings bond is currently 1.2% per year (plus the actual rate of inflation). But it will almost certainly fall when the rate is reset on May 1. The limit per person is $5,000 in electronic form at www.treasurydirect.gov and another $5,000 per person in paper form at banks. Still, you get a guarantee that a dollar saved today will be worth a dollar plus interest 16 years from now when your child goes to college. And the money compounds tax-deferred until you cash it in.

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