Using Mutual Funds to Save for College

Equation on chalkboardIt’s never too early to start saving for a child’s college education and mutual funds offer several possibilities for education savings.

Here are some tips on how to use your mutual funds to potentially help pay for college:

Earmark funds for education

To help pay for college, consider a regular mutual fund account in your name, with the funds earmarked for education. You'll retain control over the funds (perhaps minimally affecting your child's eligibility for financial aid). Contributions won't be deductible and earnings will be taxed at your rate, which is presumably higher than your child's.

Take advantage of the “kiddie tax”

Alternatively, you can put in up to $14,000 a year (in 2013) free of federal gift taxes, in your child's name through a custodial account under your state's uniform gift (or transfer) to minors act. The so-called "kiddie tax" applies to children under age 19 with unearned income. Generally, the first $1,000 of annual earnings is tax-free, and the next $1,000 is taxed at the child's rate (usually 10%). Unearned income over $2,000 is taxed at the parents' highest marginal tax rate (unless the parents are taxed at a lower rate than the child). Children age 19 and older pay taxes on all net investment income earned in the account at their tax rate, typically 10%. (These figures apply for the year 2013, are generally adjusted annually and are subject to change due to legislation.) For the 2013 tax year, the kiddie tax will be expanded to include dependents under the age of 19 and dependent full-time students under the age of 24.

Take advantage of a Coverdell Education Savings Account

Another alternative is a Coverdell Education Savings Account, formerly called an Education IRA. It is a tax-advantaged education savings account. Contributions cannot exceed $2,000 in after-tax dollars, but funds can be withdrawn free of federal income tax and penalties on earnings to pay for qualified elementary, secondary and higher education expenses.

Choosing among the mutual fund options

When choosing among the mutual fund options for your Coverdell Education Savings Account, you may consider, among other things, your particular financial circumstances, investment time horizon, tolerance for risk and whether or not you have other savings in place for education expenses. For example, if your time horizon spans beyond a decade, you may consider allocating a greater percentage of your contributions to stocks, which have greater risk but historically offered greater potential for growth than other options. Past performance, of course, does not guarantee future results. You should consider the investment objectives, risks, charges and expenses carefully before investing.

As time for paying tuition nears and fluctuations in the account value become less tolerable, you may want to rebalance your assets and reallocate contributions toward a more conservative strategy. Please note that rebalancing does not protect against losses or guarantee that an investor's goal will be met.

Keep in mind that Coverdell Education Savings Accounts aren't like IRAs. As tax-advantaged college savings plans, they can't be used for retirement investing and don't affect your eligibility or contribution limits for actual IRAs and/or tax-deferred annuity plans. Please note that rebalancing does not protect against losses or guarantee that an investor's goal will be met.

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