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Dear Dr. Don,
I have a 2-month-old baby, and want to start saving for his college expenses. At this time, our family income is not too high ($63,000) and we plan to save $25 a month for the first two years. Eventually, we will save more money as our income grows.
I have heard about Section 529 accounts, Series EE and I savings bonds, the stock market and other investments. I really don't know which one would be the best option. Are these all tax-free? Is it a good idea to put my child's name on the account instead of ours?
-- Jadyra Jump-start
 Dear
Jadyra,
It's best to split your decision into two parts: what type of account to open and what type of investments to choose. I suggest focusing on a plan for tax-advantaged college savings.
There are two types of 529 accounts:
college savings plans and prepaid tuition plans.
Both are tax-advantaged. In some states, contributions
to the account generate a state income tax deduction
and qualified distributions are free of federal
income taxes. Other states also keep these distributions
free of state income taxes.
Take a look at "College Savings 101" on Savingforcollege.com to learn more about the tax advantages available through investing in your state's program.
A Coverdell education savings account,
or CESA, is an alternative to a 529 account. You'll
have a little more flexibility in how the contributions
are invested. Like 529 accounts, qualified distributions
are free of federal income taxes.
The problem with each of these accounts is that your initial contributions may be too small to make them worthwhile. Contributing $25 a month adds up to a total of $300 for the year. Annual fees and expenses in the early years will negate a lot of your investment returns. If you earn 8 percent on your investment, you'll have a gain of $12 and a balance of $312. (You will have $150 invested, on average, that first year.) If the custodian charges a $25 annual account maintenance fee, your year-end balance will be $287.
For that reason, I'm going to recommend
that you start off with the U.S. Treasury's Savings
Bonds for Education Program. To open
this type of account, you must be at least 24
years old on the first day of the month in which
you purchase the bond. The child can be listed
as the beneficiary on the bond but can't be listed
as the bond's owner.
Qualified distributions are tax-free, provided the bond's owners meet the modified adjusted gross income requirements for the program. The income limits apply in the year the bonds are used for educational purposes, not the year the bonds were purchased. You may be able to buy the bonds using the payroll deduction plan at work.
Savings bonds have a one-year minimum holding period. I'd pick Series I bonds over Series EE bonds because they are inflation-protected. As you free up more money in your monthly budget for college savings, you should re-visit where you want to make contributions.
Once you are ready to consider Section 529 accounts or CESAs, you will have more choices in how to invest the money. For the most part, you'll be choosing between mutual funds that invest in stocks, bonds or money market instruments. The right choice will depend on the amount of time left until your baby is expected to go to college and your investment risk tolerance.
Taxable accounts (meaning non tax-advantaged accounts) in your child's name are usually a bad idea because of how they impact financial aid calculations down the road.
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