Q. What is an education IRA? Is it related to retirement planning?
A. Despite its name, an education IRA is not related to retirement savings.
An education IRA is a purely a savings vehicle for the qualified educational
expenses of a named beneficiary. You contribute to an education IRA using
after-tax dollars and direct those funds into various investment vehicles.
Even though your contributions to an education IRA are not tax deductible,
the earnings accumulate tax-free. Eventually, the original investments and
their earnings are distributed to the beneficiary to pay for qualified
educational expenses. As long as the funds are used for qualified expenses,
the earnings portion of the distribution remains tax-free. However, any
portion of the earnings not used for qualified expenses is added to the
beneficiary’s gross income. It is then subject to taxes and generally a
10-percent penalty. The funds must be used by the time the beneficiary
reaches age 30, but unused balances can be rolled over tax-free to fund an
education IRA for another family member.
The 2001 tax relief act recently expanded and clarified the use of the
education IRA. Among these changes are higher contribution limits and
broader qualified uses of the funds. Beginning in 2002, you can contribute
up to $2,000 per year to an education IRA. The contribution limit is phased
out for joint filers with an adjusted gross income (AGI) between $190,000
and $220,000. For single filers, the phase out takes place with an AGI
between $95,000 and $110,000. This restriction is imposed on the person
making the contributions into the IRA, not the beneficiary. However, many
astute financial planners can assist you in circumventing this restriction.
The 2001 tax relief act also specifies that entities such as companies,
churches, or foundations can contribute to your education IRA account.
The education IRA was originally established for higher education expenses
only. Recent changes now allow the funds to pay for elementary and secondary
expenses at private, public, or religious schools. This includes academic
tutoring, computer technology or equipment (such as internet services), room
and board, uniforms, and other supplies. The less restrictive provisions of
the new law may encourage grandparents or other relatives to fund education
IRAs starting at the birth of the child in order to assist with early
childhood education expenses. The original terms of the education IRAs also
specified that contributions end when the beneficiary reached age 18; now,
contributions can continue beyond age 18 if the beneficiary has special
needs due to a physical, mental or emotion condition (including learning
State-sponsored college savings plans (often referred to as Section 529
plans) still allow you to contribute considerably more than education IRAs -
with a $150,000 annual limit for state plans, versus the $2,000 annual limit
on education IRAs. However, the advantage to education IRAs is that you have
control over the investment of those funds. The investment of state-plan
contributions take place, more or less, behind closed doors. As always, the
best investment strategies usually combine several approaches and should be
suited to your specific investment goals and abilities. Work with your
financial planner to decide if an education IRA is right for your family.