Introducing The "Education IRA"

This article focuses on the "Education IRA," a freshly minted type of investment account that will help parents save for their children’s post-secondary education. With President Clinton’s recent signing of the Taxpayer Relief Act, billions of dollars in tax breaks have opened up for investors, students, and families.

First, a matter of nomenclature: despite its name, the Education IRA is not intended to serve investors’ retirement needs. Therefore, it is not really an Individual Retirement Account. The traditional IRA offers tax-deferred compounding. But the Education IRA provides the powerful advantage of tax-free compounding, which could make it helpful as part of a family’s plan for financing college.

Beginning in 1998, parents, guardians, or any other interested party may invest up to $500 annually in an Education IRA for a designated beneficiary, age 17 or younger. Contributions will be after-tax (i.e., nondeductible), but the money will grow tax-free and may generally be withdrawn tax-free. Of course, there is rules governing investors' use of the new account.

Terms and Conditions

Not everyone may establish an Education IRA. The contribution limit is phased out as a single taxpayer’s modified adjusted gross income increases from $95,000 to $110,000 ($150,000 to $160,000 for couples).

To avoid paying tax on distributions from the account, an investor may withdraw no more in a given tax year than the sum of that year’s qualified educational expenses, including tuition, books, and room and board. Any distribution above the qualified amount is subject to income tax, plus a 10% penalty.

There are also deadlines for both contributions to and distributions from the Education IRA. Contributions cannot be made for anyone 18 years of age or older. If the money in an Education IRA is not withdrawn by the time the beneficiary turns 30, it must be distributed to the beneficiary, who must pay income tax plus a 10% penalty on the distribution. One exception, however, is that the proceeds of an Education IRA can be transferred from the original beneficiary’s account to an Education IRA for another family member.

It is worth noting that the $500 contribution to an Education IRA may be made in addition to a contribution of up to $2,000 to a traditional or Roth IRA in the child’s name, if the child had earned income for the tax year of the contribution. There is no earned-income requirement for contributing to an Education IRA.

Education IRA versus UGMA/UTMA

Note that Education IRAs differ in two important ways from Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) accounts, which many investors now use to help children or grandchildren save for college expenses. First, there is the $500-per-year limit on the amount that can be placed in a child’s Education IRA. So, parents and grandparents can’t both contribute $500 to Education IRAs in the same year for the same beneficiary. Gift tax considerations aside, there is no cap on contributions to an UGMA. Second, earnings and withdrawals are generally tax-free for Education IRAs. Earnings on UGMA investments are taxable -- though at relatively favorable rates. Also, there may be a taxable capital gain when shares are sold in an UGMA/UTMA account.

State tuition programs and the Education IRA

The new law bars taxpayers from making contributions on behalf of one beneficiary to both an Education IRA and a state tuition program in the same tax year. About 30 states now have programs aimed at assisting parents with college savings. Since these programs vary greatly, you should consult your state for information. It may also be wise to consult a tax professional for guidance on whether a state program or an Education IRA is the better way for you to save for higher education expenses.