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Investing for child

Chris Farrell May 13, 2010

Question: We have a nine month old daughter and relatives like to give cash as gifts. I am trying to figure out the best thing to do with this money until she is old enough to need it. My thought was to use a target date mutual fund with a target date around when she is 18. That way she would have money for college, house, car, or whatever she may need at that point. What are other good options for saving this gift money for a child? Steve, Raleigh, N.C.

Answer: I like your approach. And I think target date funds are an intriguing idea.

These mutual funds are designed for people with little investment experience. The portfolios are well-diversified and the investment mix automatically gets more conservative as the target date nears.

Now, target date funds are mostly marketed as a simple retirement savings plan. But the basic idea is no different than the option of an age-based portfolio in 529 college savings plan. With an age-based portfolio the money is invested in low-cost index funds. When the student is young a high percentage of the portfolio–typically 70% to 80%–is in equities. The rest is in fixed income securities. As the student ages, the percentage invested in equities automatically shrinks and the amounts in bonds and cash increases. By the time the student is 16, equities usually comprise about a quarter of the overall portfolio.

You’ll pay dividend and capital gains taxes every year on the target date fund. The gains are tax-deferred with a 529 plan college savings plan and free of Uncle Sam’s levy (and in many cases state taxes too) if spent on qualified educational expenses. But if the money doesn’t go to college you’ll pay ordinary income tax rates on the earnings as well as a 10% penalty. The flexibility for your daughter to spend the money on what she wants is a major advantage of saving in a taxable account.

Target date funds are not all the same. A number of them are poorly designed and charge high fees. You’ll need to research the various fund offerings. One way to do that is to log on to the financial investment and database firm, Morningstar. For instance, it recently published a detailed look into the performance of target date funds.

An alternative is another approach that I like: Decide how much you’d like to invest in safe securities and how much in risky assets for your daughter. You could then buy a broad-based equity index fund as the risky side of the equation and put the rest into I-bonds. It’s a simple, low cost, and tax efficient strategy.

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