Ask the Dollar Diva By Dorothy Rosen • Bankrate.com

How do we invest for retirement and college?

Dear Dollar Diva,
We have paid off our mortgage, have no debt, and have money in savings that we want to invest for retirement and college for the children. We already participate in a 401(k) with diversified allocations. One child will be ready for college in six years, the other in 12 years.

We'd like to put our savings on automatic pilot by investing in something we can forget about until we need it. Do you think an index fund is a good way to go? Is it wise to dump a lot of money into a fund all at one time?

Before you allocate funds to investments, make sure you have enough cash put aside in a money market or certificates of deposit to cover the following:

• three to six months of living expenses
• unexpected expenses that might crop up during the year, such as replacing an appliance or putting up a fence for the puppy you swore they couldn't keep
• large expected expenses that will take place during the year such as family trips, real estate taxes and homeowners insurance

Investing for retirement

Next, you'll want to make sure you are taking full advantage of your 401(k) plans by funding them to the maximum, with or without employer's matching contributions. Next, invest in an IRA or Roth IRA if you are eligible. Go to IRS Publication 590, Individual Retirement Arrangements for rules on eligibility and limitations. The Diva's "Simple Plan or Roth IRA" has a chart showing the income phase-out ranges for the Roth.

Once you've taken advantage of all tax-deferred opportunities, including a Keogh or SEP if you file a Schedule C for self-employment income, you're ready to think about after-tax investing.

You're on track with index funds for automatic-pilot investing. Remember to think of your total investments, inside and outside your 401(k), as a single portfolio when you allocate your funds to different categories. Let's say you've chosen a medium risk portfolio as follows:

Anything that generates income or large capital gains should go into your 401(k) or other tax-deferred accounts. Bonds and growth and income funds would fall into this category, as well as other funds that spit out large, taxable capital gains at the end of the year.

For after-tax investments, look for index funds, especially tax-friendly index funds. Taxes and fees reduce investment performance, and tax-friendly index funds will minimize those pesky fees and taxes.

As far as index fund providers go, lots of companies are doing it, so you should be able to find funds that meet your needs. Vanguard is the big daddy, but check out the competition, such as Fidelity, T.RowePrice, and Charles Schwab to see what their offerings look like. Once you've selected some funds and read their prospectuses, do a final comparison with a free Quicktake Report from Morningstar.

Investing for college

For college savings, consider a qualified state tuition program, also known as a Section 529 Plan. Put yourself on automatic pilot with a savings plan that moves from equities to bonds as the child gets closer to college age.

You'll have to do some homework to select the state plan that will work best for you, and a good place to start is Joseph Hurley's Web site: Saving for college with Section 529 plans. He presents the plans offered by every participating state with a recap of their programs and links to their Web sites. And there are no tax consequences, good or bad, for out-of-state participants who are not required to file a tax return in that state.

Another option is to go the index fund route, switching to bonds when your child is within four years of the first tuition payment. For more investment ideas, read the Diva's "The gift that keeps on giving."

Should I dump a large sum of money into a fund at one time?

If you're in it for the long haul, the sooner you get your money working for you the better; dump it all and be done with it. If you're afraid of a big drop in the market the day after you empty your pockets, an event that's possible but not probable, divide the pot into 12 installments, and spread your investment payments over the next year.

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.