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College savings top gift for grandchild

Dear Dr. Don,
What investment would be the most sensible for a new grandchild? I am thinking in the $5,000 to $10,000 range.
-- Bill Baccalaureate

Dear Bill,
Congratulations, Grandpa! Like you, I think an investment in the child's future will mean a lot more in the long run to both of you than something that meets the child's current needs.

First, decide where the account will be held. Then, decide on the investment, although the type of investment can influence where you want to hold the account.

Unless you're buying a prepaid tuition plan, you're choosing to invest in stocks, bonds or cash (money market) -- or mutual funds that invest in stocks, bonds or cash. Sales commissions, account fees and expense ratios all create a drag on the account's returns, so you want to consider this aspect of investing, too.

If the goal of the investment is to fund college expenses, there are four primary choices for tax-advantaged accounts or investments: a Section 529 college savings account, a Section 529 prepaid tuition account, a Coverdell education savings account, known as a CESA, and using the federal savings bond tax exclusion.

Because you're looking in the $5,000 to $10,000 range, I'd skip the CESA, which has a maximum annual investment of $2,000.

I'd also skip using the federal savings bond tax exclusion because the bonds have to be registered in the parent's name, not the child's, and there are income restrictions on the parent's ability to take advantage of this program. However, you can learn more about the tax exclusion at TreasuryDirect.gov.

In terms of tax-advantaged accounts, that leaves you with a decision between a Section 529 college savings account and a Section 529 prepaid tuition account. If you think Junior is going to a state school, check out the prepaid tuition plan.

If you're less sure of him/her going to a state school, a college savings account may be the better choice. Check out the plans at SavingforCollege.com.

Bankrate's interview with Joe Hurley, Bankrate's college money guru, provides a nice overview and comparison of CESA and Section 529 accounts.

Taxable accounts in the form of Uniform Gift to Minors Act and Uniform Transfers to Minors Act are possible alternatives, but changes in the tax code in 2006 affecting the "kiddie tax" implications of these accounts make them less favorable.

The Bankrate feature, " IRS rules for child's investment income" explains this in greater detail. The potential for the account balances held in the student's name to reduce student aid is another issue.

So, the first concern is to determine whether to keep the money in a tax-advantaged account for college expenses or to keep the funds in a taxable account that can be used for any goal.

Talk to your tax adviser if you can't decide between the two. From there, you'll consider the types of investments for the account. Keep an eye on expenses.

College cost inflation has outpaced inflation as measured by the consumer price index, so I think you're better off investing in stocks versus bonds, although inflation-indexed securities like Treasury inflation-protected securities, also known as TIPS, can be a good choice in a tax-advantaged account.

You can learn about TIPS on the TreasuryDirect Web site. For stocks, I'd suggest that you look at investing in a no-load globally diversified index fund.

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