FOOL'S SCHOOL DAILY Q&A
Investing for Baby

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Ann Coleman (TMF AnnC)
July 25, 2001

Q. Our son was born on June 20, 2001. We received $500 from family and friends. What is the best way to invest this money for him? -- D.G.

A. Congratulations! Is he sleeping though the night yet? I ask only because I am safely out of range. Please don't throw that teddy bear at your computer!

When it comes to investing for kids, you have several options. You could:

  • Start an Education IRA
  • Contribute to a Section 529 account (state-run, prepaid college tuition plans)
  • Open a Uniform Gift (or Transfer) to Minors Act account
  • Buy eight or nine shares of Kimberly-Clark (NYSE: KMB)

I'm kidding about that last one. I never recommend specific stocks, but you will be making a quite contribution to the bottom line of the company that makes Huggies over the next two or three years!

You asked me about the "best" way, though, didn't you? OK, here is my opinion, for whatever it's worth: Open an Education IRA.

This year Education IRA contributions are limited to $500. Anyone can make the contribution -- not just parents -- though there are some income limits (similar to those for a Roth IRA). That single $500 deposit could be worth more than $3,000 by the time your son starts college. OK, that's about 10 weeks at State U. Obviously, you will have to make a few more contributions over the years, but it's a great start. Next year, the Education IRA contribution limit is being raised to $2,000. (You might want to mention that interesting fact to the family and friends who were so generous.)

A Section 529 plan is also a great way to save for college, and it will be better under the new tax law. Right now withdrawals are taxed at the student's rate (usually lower than the parents'), but starting next year withdrawals for qualified education expense will be tax-free, just like withdrawals from an Education IRA. The contribution limit is much, much higher as well. The major drawback is that you are limited to the investment choices that come with the plan. Many 529 plans are in transition now as they scramble to adjust to the new law that essentially forces them to compete with other states. I expect this to result in some great deals for investors -- next year.

It's hard to choose between the two, but since you will be able to contribute to both starting next year, you don't really lose anything by starting off with the Education IRA. That will give the states time to come up with their most attractive offerings. It's easy to open an Education IRA, and your money will go to work right away. Then if you want to look into the 529 plans, you won't be rushed. (Switching from one state plan to another is not as easy as switching brokerages.) Since you will be able to sign up for plans offered by any state, there is a lot of comparing to do. To see details on all state plans visit savingforcollege.com.

College or some other form of higher education is just about mandatory these days if one wants a good job, but if you are looking for more flexibility, a simple Uniform Transfer to Minors Act account (UTMA -- or UGMA, Uniform Gift to Minors Act, in a few states) will give your son unfettered use of the money when he turns 21 (in most states-- it varies). That's not always seen as a good thing by people who remember being 21, though, and UTMA/UGMA earnings over $1400 are taxed at your marginal tax rate until your child turns 14 under the Kiddie Tax rules. The big advantage of the UTMA account is that you are not penalized if withdrawals are not used for education expenses.

All of these choices have one thing in common: They don't do anything at all to make your money grow. Once you put money in the account, you still have to invest it in something. You could stick with something conservative like a money market fund. But if you do, your chances of growing that $500 into something significant are pretty slim. After 18 years at 5%, $500 only grows to around $1,200.

When you have a long time horizon, you can afford to risk your money in the stock market. Chances are excellent that your account will grow faster in stocks -- although there will be periods (like the present one) when it may not grow at all or may even lose ground. That's why we recommend that you start shifting some of the money out of stocks and into a fixed-income investment three years before your son is set to arrive on campus with his footlocker and new wearable computer. But that's a good 15 years in the future.

The best way for an investing novice to invest in stocks is through an index fund or index shares (a.k.a. exchange traded funds, or ETFs). The mechanism doesn't matter much, though funds are better if you want to invest small amounts frequently (an excellent idea -- make saving part of your monthly budget). The important thing is to choose an index investment that closely tracks a broad stock market index, like the S&P 500 or the Wilshire 5000, and that doesn't siphon off much of your money in expenses and commissions. Such an investment lets you participate in the growth of the U.S. economy without exposing you to the risk of picking individual stocks.

You can purchase ETFs from any broker, just like stocks. Some mutual funds are available through brokers, or you can buy them directly from the fund company. I found a great mutual fund screening tool that lets you screen funds by investment objective, minimum purchase, and expense ratio. In eight seconds I found 10 broad-market or S&P 500 index funds with minimum purchase requirements of $500 or less and expense ratios less than 0.5%.

Still awake? Get yourself a nap before you start looking for a broker.

Ann Coleman's children started sleeping through the night at 8 and 12 months of age. Now teenagers, they have acquired the ability to sleep 24 hours at a stretch. Unfortunately, she never owned stock in Kimberly-Clark. Stocks that she owns now are listed in her personal profile. The Motley Fool is investors writing for investors.

Submit a question for Ask the Fool.