Dear Joe, 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
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.
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.
Meanwhile, there are fewer investment options in a 529 plan, although these choices are more than adequate for the majority of American families. The ability to change investments is also more restricted in a 529 plan.
Also, consider whether your state offers a state income tax deduction or credit for your contributions to its 529 plan. A small number of states, including Kansas, Pennsylvania and Maine, permit a deduction for contributions to any state's 529 plan. You will not receive a state tax deduction for contributions to a Roth IRA.
If you don't mind the prospect of your child having control of the money at age 18 or 21, consider gifting some of your mutual funds to your new child before selling them. You can do this by establishing a Uniform Transfers to Minors Act, or UTMA, account.
In 2007, the first $850 of gains recognized by your child will be free from federal taxation and the next $850 will be taxed at a 5 percent capital gains rate. Above $1,700 in unearned income, the so-called kiddie tax -- which prevents parents from taking advantage of their child's lower tax rate -- kicks in.
In 2008, the caps change slightly and the 5 percent capital gains bracket becomes a zero percent bracket, meaning your child can recognize up to $1,800 in capital gains in 2008 before any money is subject to federal taxes.
Money in the UTMA account could be invested in a 529 plan to avoid taxes, including the kiddie tax, in the future. Your child will not be able to open a Roth IRA because contributions are limited to earned income.
As a final note, consider the gift-tax impact of any moves you make. Gifts into a UTMA are subject to your $12,000 gift-tax annual exclusion. So are contributions to a 529 plan for your child, although the five-year election allows you to spread contributions above $12,000 over five years to help stay within the $12,000 annual exclusion