529 plans not always best option
Meanwhile, there are fewer investment options in a 529 plan, although these choices are more than adequate for the majority of American families. The ability to change investments is also more restricted in a 529 plan.
Also, consider whether your state offers a state income tax deduction or credit for your contributions to its 529 plan. A small number of states, including Kansas, Pennsylvania and Maine, permit a deduction for contributions to any state's 529 plan. You will not receive a state tax deduction for contributions to a Roth IRA.
If you don't mind the prospect of your child having control of the money at age 18 or 21, consider gifting some of your mutual funds to your new child before selling them. You can do this by establishing a Uniform Transfers to Minors Act, or UTMA, account.
In 2007, the first $850 of gains recognized by your child will be free from federal taxation and the next $850 will be taxed at a 5 percent capital gains rate. Above $1,700 in unearned income, the so-called kiddie tax -- which prevents parents from taking advantage of their child's lower tax rate -- kicks in.
In 2008, the caps change slightly and the 5 percent capital gains bracket becomes a zero percent bracket, meaning your child can recognize up to $1,800 in capital gains in 2008 before any money is subject to federal taxes.
Money in the UTMA account could be invested in a 529 plan to avoid taxes, including the kiddie tax, in the future. Your child will not be able to open a Roth IRA because contributions are limited to earned income.
As a final note, consider the gift-tax impact of any moves you make. Gifts into a UTMA are subject to your $12,000 gift-tax annual exclusion. So are contributions to a 529 plan for your child, although the five-year election allows you to spread contributions above $12,000 over five years to help stay within the $12,000 annual exclusion.