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Starting to save for son's college

Dear Dr. Don,

I have a 5-year-old son. I am trying to start saving and investing his money for possible college. What is the best way for me to invest his $4,000 dollars? In a CD or a college fund? He will probably be able to get financial aid. I just don't want that money to lose interest if he does not use it for college.

I was thinking of CDs but want the best rate for short terms. I live in the New York area. What are the best CD rates for me to do -- a one- or two-year CD and keep investing? Or college fund? I am disabled and he also collects $167 per month. Any advice is good. And for me, my husband and I are in our 40s and don't have any retirement savings. Where do we start? -- Theresa


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Dear Theresa,
Start at the beginning. I'd put retirement savings ahead of college savings because I'm not sure I can count on the kids financing my retirement; but I am sure that they can find a way to go to college if I don't pay for it. My daughter tells me to treat her kindly because she gets to pick out my nursing home one day -- but she doesn't read this column.

To the extent that you are able to put retirement money away, take advantage of tax-advantaged retirement accounts like IRAs, Roth IRAs or employee-sponsored 401(k)s. If an employer offers a matching contribution in a 401(k) plan then, at a minimum, you should contribute up to the limit of that match. Beyond that point, it may make more sense to contribute to a Roth IRA, depending on your tax-filing status and your tax brackets. IRS Publication 590, Individual Retirement Arrangements (IRAs), can help you decide, or talk to your tax adviser.

The financial-aid formula requires the student to contribute 35 percent of their financial assets toward college expenses, but the required parental contribution is much lower. In most instances it's 5.7 percent. In general, that means that you don't want to move your money to your son's name because it will reduce the amount of his financial aid package.

The $4,000 in his name can be invested without much worry of triggering the kiddie tax so you shouldn't have to worry about tax-advantaged college-savings plans or prepaid tuition plans for these funds. The Bankrate feature, "The kiddie tax: Special rules for reporting Junior's investment income," explains the issues surrounding investing children's money, including kiddie tax implications.

With about 13 years before your son is heading off to college, planning to invest in a series of one- to two-year certificates of deposit, or CDs, is too conservative. If college-cost inflation is 6 percent next year and he's earning 4 percent in a one-year CD, then he's lost ground. While it's hard to suggest investing in long-term debt at this point in time, something that has a better chance of keeping pace with college-cost inflation makes more sense.

For money that you're contributing to his college fund, consider Series I savings bonds. The bonds are inflation-indexed, and the Savings Bonds for Education program allows the investment earnings to be tax-free for qualified education expenses, if you qualify for the program based on your adjusted gross income. Inflation, as measured by the Consumer Price Index, or CPI, may not keep pace with college-cost inflation, but having some inflation protection is better than not having any. Another reason I like these bonds as an investment is that the money stays in the parent's name, and stays available to them if they need it for some other reason prior to funding the child's college-education expenses.

Take a look at prepaid tuition programs and college savings programs. Prepaid tuition plans should be a better hedge against college-cost inflation than a college savings plan. Savingforcollege.com will allow you to compare plans in your state or in other states. Keep in mind that if you invest in another state's plan you may lose important income tax advantages, so don't take that decision lightly.

Coverdell Education Savings Accounts (CESAs) have adjusted gross income limitations and annual contribution limits, but offer more flexibility than college saving plans in how the money is invested and where the account is held.

How any of these college savings choices affect your son's eligibility for financial aid will depend on the type of account, the contributor and the beneficiary. An earlier Dr. Don column, "College fund for grandson," also has some important cautions about the sunset provisions in the tax law for college savings plans and prepaid tuition plans.

Bankrate.com's corrections policy
-- Posted: Sept. 2, 2005
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