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August 2001

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 disability).

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.

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