Should I sell my mutual funds to start a 529 account?

Should I take the money I have invested in mutual funds and start a 529 plan for my 18 month old daughter? What will the tax implications be?

529 accounts can only be funded with cash, so if you wanted to open a new 529 account using money that is currently invested in mutual funds, you would need to sell the mutual funds first.

If you have held the funds for more than one year and they are currently worth more than what you paid for them, you would have a long term capital gain. The highest rate that would apply to these gains would be 15 percent and it is possible that a 0 percent rate could apply (depending on your current tax bracket). If you have held the funds for less than a year, any gains would be taxed at ordinary income rates.

If the shares are worth less than what you paid for them, you would have a loss. This loss could be used to offset other gains and then up to $3,000 in ordinary income. Whatever losses you couldn't use this year could be carried over to future years.

It might be better (and easier) for you to simply open a new account and sign up for automatic monthly contributions. Many plans waive all fees if you commit to making monthly contributions of $25 or $50.

Remember, there is no guarantee that your daughter will attend college. The odds may be good, but if she never goes to college and there aren't any brothers or sisters to transfer the money to, taxes and a 10 percent penalty would be due on any earnings withdrawn from the 529 account that weren't used for qualified education expenses.

One of the advantages of saving for college using a 529 plan is that earnings will not be taxed until they are distributed and if the earnings are distributed to pay qualified education expenses, no federal taxes will ever be due.

For gift tax purposes, contributions to 529 plans are considered to be a gift so in 2008, you can contribute up to $12,000 to an account without the contributions being considered a taxable gift. If you want to make a larger gift, contributions of up to $60,000 are possible if you file a Federal Gift Tax return and elect to treat the deposit as if it were made over 5 years.