When investing for kids,
decide who owns what

Start by deciding on an ownership structure. In other words, whom do you want to own the investments? You or your children? If you want to be the owner, you may want to set up a Section 529 plan. All withdrawals will be free from federal income taxes, as long as the money is used for a qualified college or graduate school expense of the beneficiary you've named -- typically, your child or grandchild. (However, the money will appear as income on the child's tax return.) This tax benefit is effective through 2010, unless extended by Congress. Withdrawals for expenses other than qualified education expenditures may be subject to federal, state and penalty taxes.

One of the biggest advantages of a Section 529 plan is that you own the account. You decide who will get the money and when he or she will get it. You can even change the beneficiary to another family member. And because you can contribute large amounts of money to the plan, you can reduce the size of your taxable estate. While most 529 plans offer a lifetime contribution of at least $250,000, the yearly contribution is $11,000 without incurring the federal gift tax provided additional gifts are not made. Consult with your tax advisor before making any decisions.

If you want your children to own investments you've earmarked for them, you may want to establish either a custodial account or a Roth IRA. Let's take a quick look at both:

» Custodial accounts: You can set up a custodial account as established by either the Uniform Gift to Minors Act or the Uniform Transfers to Minors Act. This type of account may offer you some tax advantages. In these accounts, the first $800 of investment income is tax-free to a child under 14; the next $800 is taxed at the child's rate, and any amount over $1,600 will be taxed at your rate. After children reach 14, all their investment income is taxed at their rate. You should consult your tax professional for more information.

However, you will have to balance the potential tax benefits of the accounts against another factor: loss of ownership. While your children are minors, you can still own the account, but once they reach the age of majority, then the money is theirs to do with as they please -- and what they choose may not please you.

» Roth IRA: By setting up a Roth IRA for your children, you could gain some important benefits. First, a Roth IRA's earnings grow tax-free, provided certain conditions are met. If withdrawals from Roth IRAs are made in the same tax year they were contributed, it would be as if they did not occur. Also, the IRS tax code states that tax- and penalty-fee distributions must meet certain qualifications. But withdrawals cannot be used for any purpose. Again, you should consult your tax advisor before making any decisions. Keep in mind, though, that your children must have earned income if they are going to open a Roth IRA. Consequently, this type of account may be more suitable for children who are at least old enough to earn money.

No matter what type of ownership arrangement or investment accounts you choose, start investing early. Your children may only want Power Rangers or Dora the Explorer dolls right now, but, before you know it, they'll need college tuition, a car or a down payment on a home. Do what you can to be ready for those days.