The Best ETFs For Your Child's College Savings

Q: My daughter turned 5, and I've set up a 529 account for her and a custodial account as well. What are some of the best ETFs I can buy for her to get the account going? — Robert in Braintree, Mass.

A: Kudos to you for taking steps to save on behalf of your daughter. The earlier you start, the better your odds of keeping pace with rising college costs.

Before you dive in and think about specifically where to invest in a custodial account — or any account for that matter — make sure this is the best strategy at this stage of the game. A custodial account for your child should come low on your list of financial priorities.

Before picking funds, prioritize

“Make sure you are saving enough for your retirement before you focus on saving for your child,” says Mike Eklund, a certified financial planner with Financial Symmetry in Raleigh, N.C. “As they say, you can borrow for college but not for retirement.”

If you qualify for a Roth IRA — which is open to individuals whose modified adjusted gross income is less than $117,000 ($184,000 if you are married, filing jointly) — this might be a next step. “It can serve as a dual purpose,” says Eklund. While you need to wait until you’re 59½ to make tax-free withdrawals of earnings, “you can withdraw your contributions at any time,” he says.

Assuming that you’ve checked all the boxes on retirement savings, a 529 college savings plan is generally a no-brainer; these plans offer high contribution limits, a low impact on financial aid and tax-free growth and withdrawals for qualified expenses.

529s before custodial accounts...

You can participate in any state’s plan, but since you’re a resident of Massachusetts in-state contributions will earn you a state tax deduction of up to $1,000 per individual return, or $2,000 if you are married and filing jointly. What’s more, your state’s plan is considered one of the better plans, based on costs, features and reliability, according to Savingforcollege.com.

The trick with a 529 is to contribute enough to make headway against rising college costs without over-contributing. Many experts, including Eklund, recommend aiming to save half of your expected college costs in a 529 plan, assuming you can afford to do so.

If you’d like to save for your child beyond that, then you can turn your attention to a custodial account. These accounts let you set aside up to $14,000 a year ($28,000 for spouses filing jointly) in your child’s name, without having to pay a gift tax, and the funds can be used for any purpose.

You won’t the same tax breaks as with a 529 plan, but in 2016 the first $1,050 of investment income in a custodial account is tax free, and the second $1,050 is taxed at the child’s rate. Beyond that, investment income in the account is taxed at your rate until your child takes over the account.

Choosing ETFs

Now to your question of where to invest. Exchange-traded funds (ETFs) generally offer low management fees. And because ETFs are for the most part index funds — these are passively run funds that simply track a benchmark of stocks or bonds, allowing you to see exactly what the fund holds — they provide more transparency than most mutual funds.

The trade-off is you’ll pay a commission every time you buy new shares. Though ETFs hold hundreds or thousands of individual securities, their shares are bought and sold like individual stocks on an exchange. So you'll need a brokerage account to buy and hold them and must pay a commission every time you purchase.

“In this case, we would recommend a globally-diversified stock mutual fund or ETF,” says Eklund.

Most U.S. investors are guilty of “home bias,” allocating most of their assets to U.S. companies, despite the fact that they account for roughly half of the total value of the global stock market.

Globally minded funds offer another potential advantage looking out over the next decade or so, while you are saving for college. That's because foreign stocks, which have lagged U.S. shares for several years, are trading at cheaper valuations to domestic shares. As a result, foreign stocks are expected — though not guaranteed — to produce better returns over the coming decade.

The good news is, you can cover all the bases with a single global fund that invests in a mix of both U.S. and foreign stocks. A good example is Vanguard Total World Stock ETF (VT), which holds roughly half its assets in U.S. shares and a little less than half in foreign equities.

The ETF charges just 0.14% in annual expenses, while many foreign stock funds charge 1% or so. Over the past five years, the ETF has produced annual returns of 8.4%, beating around 75% of its peers.

Another option is to mix and match. For instance, you can put some of her account into a basic index fund that offers broad domestic exposure, such as the Vanguard Total Stock Market ETF (VTI). Then you can pair that with a broad foreign stock ETF like Vanguard Total International Stock ETF (VXUS), which owns shares of companies based in developed and emerging economies.

If you go this route, you will have to periodically reset the mix of those two funds to make sure that they remain in balance.

But as your daughter gets older and the account balance grows, you'll want to revisit your choices and adjust the allocation anyway — perhaps adding bond funds to the mix, for instance — to suit her changing goals.