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Bankrate's 2008 Tax Guide
Education
Take some of the sting out of the ever increasing cost of college by applying these tax-favored options.
 
Taxes loom large in college fund choice
529 plans not always best option


Dear College Money Guru,
In about one month, my wife and I are expecting our first child. We have already begun saving for the child's education, but we have been doing it through mutual funds. The sole purpose of the funds is for our children's education.

In retrospect, I wish we had opened a 529 plan. I realize we can't roll over mutual funds into 529 plans, but should we cash in our mutual funds (we have about $50,000 total in nine different funds) and open a 529 and a Roth? Should we leave the money alone? Or should we do something in between?
-- Matt

Dear Matt,
Before getting to your specific question, let's be sure you are taking care of more important and pressing issues before your first child arrives.

Do you each have a will? Have you named a guardian in case something happens to you both? How about life insurance -- do you have enough? If your answer to any of these questions is "no," pay attention to those needs first.

Now let's talk about the education savings. The income tax bite on your mutual funds can have a significant negative impact on investment returns over time. The Roth IRA and 529 plans offer the advantage of tax-deferred earnings as well as tax-free qualified distributions down the road.

If you don't have a lot of untaxed appreciation in the mutual funds, this might be a good time to liquidate at least some of those funds, set aside enough of the proceeds to pay the capital gains tax, and reinvest the balance in a Roth IRA or 529 plan. Watch "Children as tax deductions"

If the appreciation in your funds is more significant, take a close look at the impact of the capital gains on your overall tax situation. You may want to spread the gains out over two or three years. Note that capital gains tax rates are currently scheduled to increase in 2011.

In choosing between the Roth IRA and 529 plan, most financial planners agree that retirement should take higher priority and that you should fund the Roth before contributing to a 529 plan.

With a Roth IRA, you can pull out contributions at any time for any reason without tax or penalty and leave the earnings in the account for tax-free withdrawal after age 59½. A Roth IRA also offers a wide selection of mutual funds and self-directed investments.

-- Updated: Jan. 2, 2008
 
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