Chapter 3
Funding Your Financial Plans
In This Chapter
Covering your bases before investing
Meeting your goals with the help of mutual funds
In this chapter, I explain how to fit mutual funds into a thoughtful personal financial plan so the mutual funds you invest in and the other personal finance decisions you make help you achieve your goals.
One thing to remember before you dive in: Don’t become obsessed with making, saving, and investing money that you neglect what money can’t buy: your health, friends, family, and exploration of career options and hobbies.
The Story of Justine and Max
Justine and Max, both in their 20s, recently married and excited about planning their life together, heard about a free financial-planning seminar taking place at a local hotel. A financial planner taught the seminar. One of his points was, “If you want to retire by the age of 65, you need to save at least 12 percent of your income every year between now and retirement . . . the longer you wait to start saving, the more painful it’ll be.”
For the couple, the seminar was a wake-up call. On the drive home, they couldn’t stop thinking and talking about their finances and their future. Justine and Max had big plans: They wanted to buy a home, to send the not-yet-born kiddies to college, and to retire by age 65. And so it was resolved: A serious investment program must begin right away. Tomorrow, they’d fill out two applications for mutual fund companies that the financial planner had distributed to them.
Within a week, they’d set up accounts in five different mutual funds at two firms. No more paltry-return bank savings accounts — the funds they chose had been returning 10 or more percent per year! Unlike most of their 20-something friends who didn’t own funds or understand what funds were, they believed they were well on their way to realizing their dreams.
Although I have to admire Justine and Max’s initiative (that’s often the biggest hurdle to starting an investment program), I must point out the mistakes they made by investing in this fashion. The funds themselves weren’t poor choices — in fact, the funds they selected were solid: Each had competent managers, good historic performance, and reasonable fees. Among the mistakes they made:
They completely neglected investing in their employers’ retirement savings plans. They missed out on making tax-deductible contributions. By investing in mutual funds outside of their employers’ plans, they received no tax breaks.
They were steered into funds that didn’t fit their goals. They ended up with bond funds, which were okay funds as far as bond funds go. But bond funds are designed to produce current income, not growth. Justine and Max, looking to a retirement decades away, were trying to save and grow their money, not produce more current income.
To add tax insult to injury, the income generated by their bond funds was fully taxable because the funds were held outside of tax-sheltered retirement accounts. The last thing Justine and Max needed was more taxable income, not because they were rolling in money — neither Justine nor Max had a high salary — but because, as a two-income couple, they already paid significant taxes.
They didn’t adjust their spending habits to allow for their increased savings rate. In their enthusiasm to get serious about their savings, they made this error — probably the biggest one of all. Justine and Max thought they were saving more — 12 percent of their income was going into the mutual funds versus the 5 percent they’d been saving in a bank account. However, as the months rolled by, their outstanding balances on credit cards grew. In fact, when they started to invest in mutual funds, Justine and Max had $1,000 of revolving debt on a credit card at a 14 percent interest rate. Six months later, this debt had grown to $2,000.
The extra money for investment had to come from somewhere — and in Justine and Max’s case, some of it was coming from building up their credit card debt. But, because their investments were highly unlikely to return 14 percent per year, Justine and Max were actually losing money in the process.
I tell the story of Justine and Max to caution you against buying mutual funds in haste or out of fear before you have your own financial goals in mind.
Lining Up Your Ducks Before You Invest
The single biggest mistake that mutual fund investors make is investing in funds before they’re prepared — both financially and emotionally. It’s like trying to build the walls of a house without a proper foundation. You have to get your financial ship in shape — sailing out of port with leaks in the hull is sure to lead to an early, unpleasant end to your journey. And you have to figure out what you’re trying to accomplish with your investing and what you’re comfortable with.
Throughout this book, I emphasize that mutual funds are specialized tools for specific jobs. I don’t want you to pick up a tool that you don’t know how to use. This section covers the most important financial steps for you to take before you invest so you get the most from your mutual fund investments.
Pay off your consumer debts
Consumer debts include balances on credit cards and auto loans. If you carry these types of debts, do not invest in mutual funds until these consumer debts are paid off. I realize that investing money may make you feel like you’re making progress; paying off debt, on the other hand, just feels like you’re treading water. Shatter this illusion. Paying credit card interest at 14 or 18 percent while making an investment that generates only an 8 percent return isn’t even treading water; it’s sinking!
You won’t be able to earn a consistently high enough rate of return in mutual funds to exceed the interest rate you’re paying on consumer debt. Although some financial gurus claim that they can make you 15 to 20 percent per year, they can’t — not year after year. Besides, in order to try and earn these high returns, you have to take great risk. If you have consumer debt and little savings, you’re not in a position to take that much risk.
I go a step further on this issue: Not only should you delay any investing until your consumer debts are paid off, but also you should seriously consider tapping in to any existing savings (presuming you’d still have adequate emergency funds at your disposal) to pay off your debts.
Review your insurance coverage
Saving and investing is psychologically rewarding and makes many people feel more secure. But, ironically, even some good savers and investors are in precarious positions because they have major gaps in their insurance coverage. Consider the following questions:
Do you have adequate life insurance to provide for your dependents if you die?
Do you carry long-term disability insurance to replace your income in case a disability prevents you from working?
Do you have comprehensive health insurance coverage to pay for major medical expenses?
Have you purchased sufficient liability protection on your home and car to guard your assets against lawsuits?
Without adequate insurance coverage, a catastrophe could quickly wipe out your investments. The point of insurance is to eliminate the financial downside of such a disaster and protect your assets.
In reviewing your insurance, you may also discover unnecessary policies or ways to spend less on insurance, freeing up more money to invest in mutual funds. See the latest edition of my book, Personal Finance For Dummies, 6th Edition (Wiley), to discover the best ways to buy insurance and whip all of your finances into shape.
Figure out your financial goals
Mutual funds are goal-specific tools (see “Reaching Your Goals with Funds” later in this chapter), and humans are goal-driven animals, which is perhaps why the two make such a good match. Most people find that saving money is easier when they save with a purpose or goal in mind — even if their goal is as undefined as a “rainy day.” Because mutual funds tend to be pretty specific in what they’re designed to do, the more defined your goal, the more capable you are to make the most of your mutual fund money.
Granted, your goals and needs will change over time, so these determinations don’t have to be carved in stone. But unless you have a general idea of what you’re going to do with the savings down the road, you won’t really be able to thoughtfully choose suitable mutual funds. Common financial goals include saving for retirement, a home purchase, an emergency reserve, and stuff like that. In the second half of this chapter, I talk more about the goals mutual funds can help you to accomplish.
Another benefit of pondering your goals is that you better understand how much risk you need to take to accomplish your goals. Seeing the amount you need to save to achieve your dreams may encourage you to invest in more growth-oriented funds. Conversely, if you find that your nest egg is substantial, given what your aspirations are, you may scale back on the riskiness of your fund investments.
Determine how much you’re saving
Many folks don’t know what their savings rate is. By savings rate, I mean, over a calendar year, how did your spending compare with your income? For example, if you earned $40,000 last year, and $38,000 of it got spent on taxes, food, clothing, rent, insurance, and other fun things, you saved $2,000. Your savings rate then would be 5 percent ($2,000 of savings divided by your income of $40,000).
If you already know that your rate is low, nonexistent, or negative, you can safely skip this step because you also already know that you need to save more. But figuring out your savings rate can be a real eye-opener.
Examine your spending and income
To save more, you must reduce your spending, increase your income, or both. This isn’t rocket science, but it’s easier said than done.
For most people, reducing spending is the more feasible option. But where do you begin? First, figure out where your money is going. You may have some general idea, but you need to have facts. Get out your checkbook and debit card records, credit card bills, and any other documentation of your spending history and tally up how much you spend on dining out, operating your car(s), paying your taxes, and everything else. When you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate.
Earning more income may help you save more to invest if you can get a higher-paying job or increase the number of hours you’re willing to work. Watch out, though: Many people’s spending has a nasty habit of soaking up increases in income. If you’re already working many hours, tightening the belt on your spending is better for your emotional and social well-being.
Maximize tax-deferred retirement account savings
Saving money is difficult for most people. Don’t make a tough job impossible by forsaking the terrific tax benefits that come from investing through retirement savings accounts. Employer-based 401(k) and 403(b) retirement plans offer substantial tax benefits. Contributions into these plans are generally federal- and state-tax-deductible. And after the money is invested inside these plans, the growth on your contributions is tax-sheltered as well. Furthermore, some employers will match a portion of your contributions.
Some investors make the common mistake of neglecting to take advantage of retirement accounts in their enthusiasm to invest in nonretirement accounts. Doing so can cost you hundreds of thousands of dollars over the years. Fund companies are happy to encourage this financially detrimental behavior, too. They lure you into their funds without educating you about using your employer’s retirement plan first because the more you invest through your employer’s plan, the less you have available to separately invest in their funds.
Determine your tax bracket
When you’re investing in mutual funds outside of tax-sheltered retirement accounts, the profits and distributions that your funds produce are subject to taxation. So the type of fund that makes sense for you depends, at least partially, on your tax situation.
If you’re in a high income tax bracket, give preference to mutual funds such as tax-free bond funds and stock funds with low levels of distributions (especially highly taxed short-term capital gains). In other words, focus more on stock funds that derive more of their expected returns from appreciation rather than from taxable distributions. If you’re in a low bracket, avoid tax-free bond funds because you end up with a lower return than in taxable bond funds. (In Part IV of this book, I explain how to select the best fund types to fit your tax status.)
Assess the risk you’re comfortable with
Think back over your investing career. You may not be a star money manager, but you’ve already made some investing decisions. For instance, leaving your excess money in a bank savings or checking account is a decision — it may indicate that you fear volatile investments.
How would you deal with an investment that dropped 10 to 50 percent in a year? Some of the more aggressive mutual funds that specialize in volatile securities like growth stocks, small company stocks, emerging market stocks, and long-term and low-quality bonds can quickly fall. If you can’t stomach big waves in the financial markets, don’t get in a small boat that you’ll want to bail out of in a storm. Selling after a large drop is the equivalent of jumping in to the frothing sea at the peak of a pounding storm.
You can invest in the riskier types of securities by selecting well-diversified mutual funds that mix a dash of aggressive securities with a healthy helping of more stable investments. For example, you can purchase an international fund that invests the bulk of its money in companies of varying sizes in established economies and that has a small portion invested in riskier, emerging economies. That would be safer than investing the same chunk in a fund that invests solely in small companies that are just in emerging countries.
Review current investment holdings
Many people have a tendency to compartmentalize their investments: IRA money here, 401(k) there, brokerage account somewhere else. Part of making sound investment decisions is to examine how the pieces fit together to make up the whole. That’s where jargon like asset allocation comes into play. Asset allocation simply means how your investments are divvied up among the major types of securities or funds, such as money market, bond, United States (U.S.) stock, international stock, and so on.
Another reason to review your current investments before you buy into new mutual funds is that some housecleaning may be in order. You may discover holdings that don’t fit with your objectives or tax situation. Perhaps you’ll decide to clear out some of the individual securities that you know you can’t adequately follow and that clutter your life.
Consider other “investment” possibilities
Mutual funds are a fine way to invest your money but hardly the only way. You can also invest in real estate, invest in your own business or someone else’s, or pay down mortgage debt more quickly. Again, what makes sense for you depends on your goals and personal preferences. If you dislike taking risks and detest volatile investments, paying down your mortgage may make better sense than investing in mutual funds.
Reaching Your Goals with Funds
Mutual funds can help you achieve various financial goals. The rest of this chapter gives an overview of some of these more common goals — saving for retirement, buying a home, paying for college costs, and so on — that you can tackle with the help of mutual funds. For each goal, I discuss what kinds of funds are best suited to it and point you to the part of the book that discusses that kind of fund in greater detail.
As you understand more about this process, notice that the time horizon of your goal — in other words, how much time you have between now and when you need the money — largely determines what kind of fund is appropriate:
If you need to tap in to the money within two or three years or less, a money market or short-term bond fund may fit the bill.
If your time horizon falls between three and seven years, you want to focus on bond funds.
For long-term goals, seven or more years down the road, stock funds are probably your main ticket.
But time horizon isn’t the only issue. Your tax bracket, for example, is another important consideration in mutual fund selection. (See Chapter 10 for more about taxes.) Other variables are goal specific, so take a closer look at the goals themselves. Throughout the rest of this chapter, I also give you plenty of non-mutual-fund-related tips on how to tackle these goals. Remember: Mutual funds are just part of the overall picture and a means to the end of achieving your goals.
The financial pillow — an emergency reserve
Before you save money toward goals, accumulate an amount of money equal to about three to six months of your household’s living expenses. This fund isn’t for keeping up on the latest consumer technology gadgets. It’s for emergency purposes: for your living expenses when you’re between jobs, for unexpected medical bills, for a last-minute plane ticket to visit an ailing relative. Basically, it’s a fund to cushion your fall when life unexpectedly trips you up. Call it your pillow fund. You’ll be amazed how much of a stress reducer a pillow fund is.
How much you save in this fund and how quickly you build it up depends on the stability of your income and the depth of your family support. If your job is steady and your folks are still there for you, then you can keep the size of this fund on the smaller side. On the other hand, if your income is erratic and you have no ties to benevolent family members, you may want to consider building up this fund to a year’s worth of expenses.
The ideal savings vehicle for your emergency reserve fund is a money market fund. See Chapter 11 for an in-depth discussion of money market funds and a list of the best ones to choose from.
The golden egg — investing for retirement
Uncle Sam gives major tax breaks for retirement account contributions. This deal is one you can’t afford to pass up. The mistake that many people at all income levels make with retirement accounts is not taking advantage of them and delaying the age at which they start to sock money away. The sooner you start to save, the less painful it is each year, because your contributions have more years to compound.
Each decade you delay approximately doubles the percentage of your earnings that you should save to meet your goals. For example, if saving 5 percent per year starting in your early 20s would get you to your retirement goal, waiting until your 30s may mean socking away 10 percent; waiting until your 40s, 20 percent; beyond that, the numbers get troubling.
Taking advantage of saving and investing in tax-deductible retirement accounts should be your number-one financial priority (unless you’re still paying off high-interest consumer debt on credit cards or an auto loan).
Retirement accounts should be called tax-reduction accounts. If they were called that, people might be more excited about contributing to them. For many people, avoiding higher taxes is the motivating force that opens the account and starts the contributions. Suppose you’re paying about 35 percent between federal and state income taxes on your last dollars of income (see Chapter 10 to determine your tax bracket). For most of the retirement accounts described in this chapter, for every $1,000 you contribute, you save yourself about $350 in taxes in the year that you make the contribution. You can invest this savings until it’s taxed when withdrawn in retirement. Some employers will match a portion of your contributions to company-sponsored plans, such as 401(k) plans — getting you extra dollars for free.
On average, most people need about 70 to 80 percent of their annual preretirement income throughout retirement to maintain their standard of living. If you haven’t recently thought about what your retirement goals are, looked into what you can expect from Social Security (okay, cease the giggling), or calculated how much you should be saving for retirement, now’s the time to do it. My book, Personal Finance For Dummies, 6th Edition (Wiley), goes through all the necessary details and explains how to come up with more money to invest.
When you earn employment income (or receive alimony), you have the option of putting money away in a retirement account that compounds without taxation until you withdraw the money. With many retirement accounts, you can elect to use mutual funds as your retirement account investment option. And if you have retirement money in some other investment option, you may be able to transfer it into a mutual fund company (see Chapter 16).
If you have access to more than one type of retirement account, prioritize which accounts to use by what they give you in return. Your first contributions should be to employer-based plans that match your contributions. After that, contribute to any other employer or self-employed plans that allow tax-deductible contributions. If you’ve contributed the maximum possible to tax-deductible plans or don’t have access to such plans, contribute to an IRA. The following sections include the major types of accounts and explain how to determine whether you’re eligible for them.
401(k) plans
For-profit companies typically offer 401(k) plans, which typically allow you to save up to $16,500 per year (tax year 2010), $22,000 for those 50 and older. Your contributions to a 401(k) are excluded from your reported income and are free from federal and state income taxes but not from FICA (Social Security) taxes.
Absolutely don’t miss out on contributing to your employer’s 401(k) plan if your employer matches a portion of your contributions. Your company, for example, may match half of your first 6 percent of contributions (so you save a lot of taxes and get a bonus from the company). Check with your company’s benefits department for your plan’s details.
Smaller companies (those with fewer than 100 employees) can consider offering 401(k) plans, too. In the past, administering a 401(k) was prohibitively expensive for smaller companies. If your company is interested in this option, contact a mutual fund organization, such as T. Rowe Price, Vanguard, or Fidelity, or a discount brokerage house, such as Charles Schwab or TD Ameritrade.
403(b) plans
Many nonprofit organizations offer 403(b) plans to their employees. As with a 401(k), your contributions are federal- and state-tax-deductible. The 403(b) plans often are referred to as tax-sheltered annuities, the name for insurance-company investments that satisfy the requirements for 403(b) plans. No-load (commission-free) mutual funds can be used in 403(b) plans. Check which mutual fund companies your employer offers you to invest through — I hope you have access to the better ones covered in Chapter 9.
Employees of nonprofit organizations generally are allowed to contribute up to 20 percent or $16,500 of their salaries ($22,000 for those individuals 50 and older) — whichever is less. Employees who have 15 or more years of service may be allowed to contribute more. Ask your employee benefits department or the investment provider for the 403(b) plan (or your tax adviser) about eligibility requirements and details about your personal contribution limits.
If you work for a nonprofit or public-sector organization that doesn’t offer this benefit, make a fuss and insist on it. Nonprofit organizations have no excuse not to offer a 403(b) plan to their employees. This type of plan includes virtually no out-of-pocket setup expenses or ongoing accounting fees like a 401(k) (see the preceding section). The only requirement is that the organization must deduct the appropriate contribution from employees’ paychecks and send the money to the investment company that handles the 403(b) plan. (Some state and local governments offer plans that are quite similar to 403(b) plans and are known as Section 457 plans.)
Small business plans
If you’re self-employed or a small business owner, you can establish your own retirement savings plans. Simplified employee pension individual retirement account (SEP-IRA) plans require little paperwork to set up. They allow you to sock away 20 percent of your self-employment income (business revenue minus expenses) up to a maximum of $49,000 per year. Each year, you decide the amount you want to contribute — you have no minimums. Your contributions to a SEP-IRA are deducted from your taxable income, saving you big-time on federal and state taxes. As with other retirement plans, your money compounds without taxation until withdrawal.
Keogh (profit sharing) plans are another retirement savings option for the self-employed. They can and should be established through the no-load fund providers recommended in this book. Keogh plans require a bit more paperwork to set up and administer than SEP-IRAs do. (I show you the differences in Chapter 16.) Keoghs now have the same contribution limits as SEP-IRAs — 20 percent of your self-employment income (revenue less your expenses), up to a maximum of $49,000 per year.
Keogh plans allow business owners to maximize the contributions to which they’re entitled relative to employees in two ways:
Keogh plans allow vesting schedules, which require employees to remain with the company a number of years before they earn the right to their retirement account balances. If an employee leaves prior to being fully vested, the unvested balance reverts to the remaining plan participants.
Keogh plans allow for Social Security integration. Integration effectively enables high-income earners (usually the owners) to receive larger percentage contributions for their accounts than the less highly compensated employees. The logic behind this benefit is that Social Security taxes top out when you earn more than $106,800 (for tax year 2010). Social Security integration allows you to make up for this ceiling.
When establishing your Keogh plan at a mutual fund or discount brokerage, ask what features its plans allow — especially if you have employees and are interested in vesting schedules and Social Security integration.
Individual Retirement Accounts (IRAs)
Anyone with employment (or alimony) income can contribute to Individual Retirement Accounts (IRAs). You may contribute up to $5,000 each year ($6,000 if you’re age 50 and older) or the amount of your employment or alimony income if it’s less than these amounts in a year. If you’re a nonworking spouse, you may be eligible to contribute into a spousal IRA.
Your contributions to an IRA might be tax deductible. For the tax year 2010, check out these eligibilities:
If you’re single and your adjusted gross income (AGI) is $56,000 or less for the year, you can deduct your IRA contribution.
If you’re married and file your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $89,000 per year or less.
If you make more than these amounts, you can take a full IRA deduction if you aren’t an active participant in any retirement plan. To know for certain whether you’re an active participant is to look at the W-2 form that your employer sends you early in the year to file with your tax returns. Little boxes indicate whether you’re an active participant in a pension or deferred-compensation plan. If either box is checked, you’re an active participant.
If you’re a single-income earner with an AGI above $56,000 but below $66,000, or part of a couple with an AGI above $89,000 but below $109,000, you’re eligible for a partial IRA deduction, even if you’re an active participant. The size of the IRA deduction that you may claim depends on where you fall in the income range. For example, a single-income earner at $61,000 is entitled to half ($2,500) of the full IRA deduction (assuming they are under age 50) because his or her income falls halfway between $56,000 and $66,000. (Note: These thresholds are for tax year 2010. They’ll increase in the tax years ahead.)
If you yourself are not an active participant in a retirement, but your spouse is an active participant, then you may take a full IRA if your AGI is $167,000 or less. A partial is allowed in this case if your AGI is between $167,000 to $177,000.
If you can’t deduct your contribution to a standard IRA account, consider making a nondeductible contribution to a newer type of IRA account called the Roth IRA. Single taxpayers with an AGI of $105,000 or less and joint filers with an AGI of $167,000 or less can contribute up to $5,000 per year to a Roth IRA ($6,000 for those individuals age 50 and older). Although the contribution isn’t deductible, earnings inside the account are shielded from taxes, and unlike a standard IRA, qualified withdrawals from the account, including investment earnings, are free from income tax.
To make a qualified withdrawal from a Roth IRA, you must be at least 591//2 and have held the account for at least five years. An exception to the age rule is made for first-time homebuyers, who are allowed to withdraw up to $10,000 toward the down payment on a principal residence.
The white picket fence — saving for a home
A place to call your own is certainly the most tangible element of the American dream. Not only does a home generally appreciate in value over the long term, but it also should keep you dry in a thunderstorm (assuming, of course, that you have a good roof!).
To get the best mortgage terms for a house, you should aim for making a down payment of 20 percent of the purchase price. (For a $250,000 home, that’s $50,000.) So unless you have some other sources available (such as a loan from your parents), you have some saving up to do.
If you’re looking to buy a home soon, then a money market fund is the best place to store your down payment money (see Chapter 11). If your target purchase date is in a few years, then consider a short-term bond fund (see Chapter 12). In the rare case that you start saving a decade or more in advance, you can choose a balanced mix of stocks and bonds.
The ivory tower — saving for college
A college education for the kiddies is certainly part of the American dream today — not surprising when you consider that a college degree has quickly replaced the high school diploma as the entrance bar to the U.S. job market. Unfortunately, the financial services industry has fully exploited the opportunity to deepen parental anxiety over educational expenses. Although mutual funds can help send your kids off to college, their specific role may be different from what you’d expect.
Saving in your own name
Few subject areas have more misinformation and bad advice than what is dished out on investing for your children’s college expenses. Too many investment firms publish free guides that contain poor advice and scare tactics. Their basic premise is that, by the time your tyke reaches age 18 or so, college is going to cost more money than you could possibly imagine. Thus, you’d better start saving a lot of money as soon as possible. Otherwise, you’ll have to look your 18-year-old in the eyes some day and say, “Sorry, we can’t afford to send you to the college you have your heart set on.”
Yes, college is expensive, and it’s not getting cheaper. But what the financial services companies don’t like to tell you is that you don’t have to pay for all of it yourself. Thanks to financial aid, most people don’t. By financial aid, I mean more than just grants and scholarships; I’m also talking about low-cost loans, which are by far and away the most common form of aid.
What’s really sad about the scare tactics some investment companies use is that these tactics effectively encourage parents to establish investment accounts in their children’s names. The drawbacks for doing so are twofold:
You limit the amount of financial aid for which your child is eligible. The financial aid system heavily penalizes money held in your child’s name by assuming that about 20 percent of the money in your child’s name (for example, in custodial accounts) should be used annually toward college costs. By contrast, only 6 percent of the nonretirement money held in your name is considered available for college expenses annually.
You give your child free rein over your hard-earned investment. When you place money in your child’s name, he or she has a legal right to that money in most states at age 18 or 21. That means that your 18- or 21-year-old could spend the money on an around-the-world junket, a new sports car, or anything else his or her young mind can dream up. Because you have no way of knowing in advance how responsible your children will be when they reach ages 18 or 21, you’re better off keeping money earmarked for their college educations out of their names.
If you can and want to pay for the full cost of your child’s education, you have an income tax incentive to put money in your child’s name. Under what’s known as the kiddie tax system, income generated by investments held in your child’s name is usually taxed at a lower rate than your own. But remember that by saving money in a child’s name, you’re reducing that child’s chances for financial aid. That’s why I say don’t invest in your child’s name unless you want to pay for your child’s full college costs yourself.
You get the benefits of tax-deferred growth and professional investment management by mutual fund companies through 529 plans. You may derive some state tax perks as well using a 529 plan. Because the money in 529 plans is earmarked for college, however, investing in these plans may have some negative consequences on college financial aid.
Using mutual funds for college cost funding
To keep up with or stay ahead of college price increases (which are rising faster than overall inflation), you must invest for growth. At the same time, you have to keep an eye on your time horizon; kids grow up fast (see “Reaching Your Goals with Funds” earlier in the chapter.)
The younger your child is, the more years you have before you need to tap the money and, therefore, the greater the risk. A simple rule: Take a number between 30 (if you’re aggressive) and 50 (if you’re more conservative) and add that to your child’s age. Got that number? That’s the percentage you should put in bonds; the rest should go into stocks. Be sure to continually adjust the mix as your child gets older.
For a list of good stock and bond funds to invest in, see Chapters 11 and 12. Pay particular attention to hybrid funds, which invest in both stocks and bonds and may already reflect your desired mix. If you want to find out more about getting your finances in order and planning for college costs, read my book Personal Finance For Dummies, 6th Edition (Wiley).