Your child just graduated, and, being a wise parent, you know she'd really like mutual fund shares as opposed to, say, three weeks in Italy. But you wonder: What is the best type of fund to buy for a graduate?
The answer: a cheap one, within a Roth IRA, and preferably one that allows her to add small amounts of money to it over time.
First, prepare yourself. Most graduates will not jump for joy when they get their first prospectus. You may be inclined to make your grad read the prospectus. Don't. Your child could become a rock star and make you the subject of an invective-laden, yet eminently danceable, Top 40 hit.
Nevertheless, your idea is a good one. A $1,000 investment 40 years ago that averaged 7% a year would be worth about $15,000 today.
And that's conservative, incidentally. With dividends reinvested, the Standard and Poor's 500-stock index gained an average 11.38% a year the past 40 years, despite periods of sky-high inflation and eight bear markets, two of the face-melting variety. A $1,000 investment in the S&P 500 at its historical rate would be worth more than $70,000 today.
Let's start with the criteria for choosing your child's fund, one by one. First: stocks or bonds? That's easy. Even if your graduate is so conservative that he shouts "I'm ruined!" when he drops a nickel down the sewer, he should be in stocks if he's investing for the next 40 years. Over long periods of time — and 40 years is long — stocks tend to return more than bonds or bank CDs.
Next: Cheapness is key, especially if you're looking for an investment that will last your child's working life, which should be roughly 40 years. Expenses wilt the value of a long-term investment like rain on a paper mortarboard.
For example, let's say that your grad's fund earns 7%, but management takes one percentage point a year in fees. Your grad's investment earns 6% a year instead of 7%, and your child is left with $10,286 — a 30% bite out of her gain.
You also want to find a fund that will accept a small minimum initial investment, especially if you've just finished paying four years of tuition. For a long time, finding funds with low minimum initial investments was an annoying problem, especially since mutual funds were designed for people of modest means. A $2,500 initial investment is a lot of money in most households.
Fortunately, some discount brokerages will let you start with a very low minimum, especially if you're opening an individual retirement account. T D Ameritrade, for example, has no minimum to open an IRA. Neither does Charles Schwab. Both offer wide ranges of funds and investments, should your graduate decide to take an interest in investing later on.
And at both brokerages, you can buy a low-cost exchange-traded fund, or ETF, typically without charge. TD Ameritrade, for example, will let you buy the iShares Russell 3000 ETF (IWV) with no commission. The fund tracks an index that follows virtually all U.S. stocks and charges just 0.2% a year, or $2 per $1,000 invested.
If you decide on Schwab, consider the Schwab Broad Market ETF (SCHB), which follows 2,500 U.S. stocks and charges just 0.04% a year, or 40 cents per $1,000 invested.
Finally, you should put your grad's savings into a Roth IRA, which will serve two purposes. The first is to shield dividends and gains from taxes, an enormous savings over time. You pay into a Roth with after-tax money, but principal and earnings are free from taxes on withdrawal at retirement, provided you've held the investment for at least five years, and you're 59½ when you retire.
The second is to provide some small barrier to your grad saying "thanks," selling the fund, and heading to Italy for a few weeks. In reality, you can withdraw your principal from a Roth at any time without penalty, which isn't that much of a barrier. But taking out earnings before retirement will require a 10% penalty on the amount withdrawn — as well as ordinary income taxes on the amount taken out. As the account grows in value, taking withdrawals will feel more onerous and become more unlikely.
Your child must have at least as much earned income as the amount you put in. For 2014, the maximum contribution for a single taxpayer earning $114,000 or less is $5,500.
Now, a one-time Roth IRA contribution of $1,000 isn't going to free your graduate from retirement worries. Even if the fund earns 12% a year, she's not going to live large on the proceeds. But let's say she adds $100 a month to the fund over the next 40 years and earns 7%. She'll have more than $270,000 in retirement, and she'll credit you with getting her started. That's a pretty darn good gift.