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THE EDUCATION IRA 

The Taxpayer Relief Act of 1997 created a new way to save money for college costs - the Education IRA.  Unlike the Individual Retirement Account (IRA) you may hold now, the Education IRA has nothing to do with retirement.  However, the concept is similar. 

According to the new legislation, eligible individuals may contribute up to $500 ($2000 effective with the Tax Act of 2001) each calendar year on behalf of any child under the age of 18.  Any earnings from these contributions will grow on a tax-deferred basis.  Then, when money is taken out of the Education IRA for college, the distribution is tax free as long as it does not exceed the child’s qualified higher education expenses. 

HOW THE EDUCATION IRA WORKS 

Annual nondeductible contributions to an Education IRA of up to $500 ($2000 effective with the Tax Act of 2001) per beneficiary are permitted.  Funds are then held by a custodian (bank or similar financial institution) and invested on a tax-free basis.  When the funds are withdrawn, no tax is due as long as those funds do not exceed the costs of the child’s college tuition, fees, books and basic room and board. 

Single taxpayers with adjusted gross income (AGI) of less than $95,000 or couples filing jointly with AGI of less than $150,000 are eligible to make the maximum contribution to an Education IRA.  This contribution limit phases out completely for single taxpayers at $110,000 and for couples filing jointly at $160,000. 

Parents may establish an Education IRA for each child.  Friends, grandparents or other relatives may also establish an Education IRA for a child.  In fact, anyone, including the child, who meets the income eligibility requirements, may contribute to help a child build a nest egg for college.  Keep in mind, however, that $500 ($2000 effective with the Tax Act of 2001) per child per year is the maximum aggregate amount that may be contributed from all people involved.  An excess contribution can be subject to a 6% excise tax. 

There is nothing in the law to prohibit an individual from contributing to his or her own Education IRA.  If a potential contributor has income exceeding the threshold amount, he or she could gift the funds (subject to the $10,000/$20,000 annual exclusion limit) to the child so that the child can contribute the money on his/her own. 

DISTRIBUTION OF ASSETS 

Funds can be withdrawn for qualified higher education expenses at an eligible college, university or vocational school.  Regular income tax rates and a 10% penalty apply if funds are used for non-qualified purposes or exceed the permitted amounts. 

Although contributions to the Education IRA cannot be made after the designated beneficiary reaches age 18, the funds can be distributed until age 30.  Distribution of the account balance must be made by age 30 or the money will be taxed to the beneficiary and subject to the 10% penalty.  Any unused funds may be transferred tax-free and penalty free, within 60 days of distribution, to another family member’s Education IRA. 

SUMMARY 

The cost of attending college is staggering and will most probably continue to rise.  The Education IRA may help defray this burden for families planning for their children’s future college funding.  The key is to start early.  While an annual $500 ($2000 effective with the Tax Act of 2001) contribution may not seem like much in the whole scheme of things, the tax-free growth can make the Education IRA a powerful source of funds to meet higher education expenses. 

Source:  Tax Facts 1, 2001

Securities offered through Sigma Financial Corporation. A registered broker/dealer. Member FINRA & SIPC.

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Last modified: 11/04/07