 Saving
for a newborn's education
|
 Dear
Dr. Don,
I have a newborn son. I have $2,000 to invest
for him at this time. What would be the best way to handle this
for his future?
-- John Jumpstart
 Dear
John,
Thanks to last year's changes in the tax code you have more
options now than ever for tax advantaged college savings. The three main types
of accounts to choose from are:
- Coverdell Education Savings
Accounts (CESAs)
- Section 529 College Savings Plans or Prepaid
Tuition Plans
- Savings Bonds for Education
Education
IRAs have been renamed Coverdell Education Savings Accounts. (The old name didn't
make much sense, but people haven't gotten used to this new name yet.) CESAs
are your most flexible choice because you can invest the money in a brokerage
account, bank account, or mutual fund. This gives you a measure of control over
the annual expenses and fees paid and the widest range of choice in how the money
is invested. The contribution limits per beneficiary have
increased to $2,000 since the 2002 tax year. Contributions are made with after-tax
dollars but qualified distributions are free of federal income taxes. Section
529 plans are named for the section of the tax code that established these plans.
Most states offer both a prepaid tuition plan and a college savings plan. College
savings plans tend to be more portable than prepaid tuition plans, which could
be important if your child enrolls in an out-of-state school. College
savings plans also offer a choice in how the account is invested, while prepaid
tuition plans guarantee that your tuition purchase is inflation adjusted to the
plan's tuition benchmark -- typically the state university tuition schedule.
Qualified distributions from a Section
529 plan are free of federal income taxes. Contributions
are made with after-tax dollars for federal income
tax purposes but the deductibility of contributions
and exclusion of income for qualified distributions
varies for state tax purposes.
So the best place to start shopping for
a Section 529 plan is in your home state because there may be tax advantages in
making contributions to your state's plan that won't apply if you contribute to
another state's plan. (This can be a good reason not to use a Section 529 plan
offered by your employer.) Savingforcollege.com
ranks the state plans on a 1-to-5 mortarboard scale for both in-state and out-of-state
accounts and the site's 529
Evaluator provides a goal-oriented method for deciding between plans. Changes
to the tax code permit schools to start up their own Section 529 plans but school
specific plans aren't available yet. Contacting a school's financial aid department
would be the easiest way to find out if an individual school expects to offer
a Section 529 plan. I like the Savings Bonds for Education
program for people that don't have an emergency
fund but want to get started saving for their children's education. The bonds
are registered in the parent's name and you can cash in the bonds in a financial
emergency without triggering any tax penalties, although you will owe income taxes
on the interest income. There is also an interest penalty if you sell the bonds
within five years of purchase, and you have to hold the savings bonds for at least
six months before you can sell them. When the savings bonds
are used for qualified education expenses, the interest income is free of federal
taxation as long as the bond owner's income doesn't exceed established income
limitations. The earnings on U.S. Savings Bonds are free of state and local taxes.
See the Bureau of Public Debt's Savings
Bonds for Education page for complete details on this program. In choosing
between the Series I bonds and the Series EE bonds, I'd recommend the Series I
bonds because the interest paid on these bonds is indexed to the inflation rate,
as measured by the Consumer Price Index (CPI). If you like
managing your own investments and have been generally pleased with your results,
there's a lot to be said for a CESA. Your state may offer tax incentives that
make contributing to a Section 529 plan more attractive than a CESA. Section 529
plans also don't have the income restrictions that are part of both the CESAs
and the Savings Bond programs. However, if you don't
have an emergency fund, consider the Savings Bonds for Education plan. Consult
with your tax professional if it's not clear which type of account is right for
you. | 
