The cost of college tuition has historically grown at a faster rate than inflation, making it increasingly expensive for the younger generation. Simply saving money for college can be difficult; especially if interest earned on that money is low. Investing money in mutual funds offers education savers a way to get better returns on their savings, and buying mutual funds in a tax deferred savings account can allow that money to grow tax free until you need it.
Time Horizons and Stock Funds
There is an important relationship between investment risk and time that will determine which type of investment is right for you. Stocks can be risky over the short run, but risk is significantly reduced when holding stocks for the long term. If the money you are saving for education will not be used for at least five years, a stock mutual fund offers better returns than almost all other types of investments.
Fixed Income and Money Market Funds
Money market funds offer the lowest rates of return, but returns are reliable and the money held in these accounts is guaranteed. Fixed income, or bond funds, offer higher rates of return, and while they can be more volatile than money market funds, they are more stable than stock funds. If you need the money for education in the next one to five years, you are better off buying a bond fund. Any money you will need over the next year should be held in a money market fund.
Managed or Index Funds
Mutual funds can be actively managed by a professional investment manager or they can be designed to behave just like a major market index, such as the S&P 500 or a bond index. According to The Motley Fool, actively managed funds, on average, under perform index funds by roughly 2 percent per year. Thus, you are likely better off choosing an index fund for your education savings.
Taxes can take a big bite out of investment returns. This is especially true with mutual funds, which are required to pass on capital gains tax on stocks and bonds they sell to investors at the end of each year. The Coverdell Education Savings Account, or ESA, is a government program that allows you to invest up to $2,000 each year. Money in an ESA can be invested in mutual funds and other investments and it is allowed to grow tax free until it is used for education.