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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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