Last week we discussed the Lifetime Learning Credit. This week, we'll look at yet another tax-saving education provision that was included in the 1997 Taxpayer Relief Act: The Education IRA.
An Education IRA (which really isn't an IRA at all, in the true sense of the word) is a custodial account or trust, usually maintained by a bank or financial organization, exclusively for the purpose of paying the qualified higher education expenses of the designated beneficiary. Education IRAs must accept contributions only in cash, and may not accept contributions for a beneficiary after the beneficiary turns 18. In addition, the education IRA may not accept contributions of more than $500 (except for rollover contributions) for any year.
Example: Mom and Dad want to establish an education IRA for little Sissy. Mom wants to donate $500, Dad wants to donate $500, and even Grandpa wants to donate $500. Can't do it. Little Sissy (as the beneficiary) is limited to only one $500 contribution into her education IRA account per year, regardless of the source of the funds.
Any individual may contribute a maximum of $500 a year to an education IRA for the benefit of any person under age 18. But the $500 contribution limit is phased out ratably for contributors with modified Adjusted Gross Income (AGI) between $95,000 and $110,000 for single persons and between $150,000 and $160,000 for joint filers. What this means is that the full $500 contribution can be made if your modified AGI is less than $95,000 for single people ($150,000 for joint), but NO contribution can be made if your AGI is $110,000 ($160,000 for joint). In between the phase-out ranges, the education IRA contribution is reduced.
Example: Grandpa, a single person, wants to establish an education IRA for little Johnny. But grandpa's AGI is $100,000. His maximum education to little Johnny's education IRA account would be only $333 because of the phase-out rules.
But you should note that, unlike other IRAs, a person can make a contribution to an education IRA even if that person has no compensation income for that tax year. This being the case, there is no reason that Grandpa can't give a $500 gift to little Johnny. Johnny can then turn around and open his OWN education IRA account for the full $500, since Johnny is well under the income limitations.
Distributions from an education IRA are tax free if the beneficiary's qualified higher education expenses for the year equal or exceed the education IRA distribution for that year.
Example: Dad contributes $500 per year to an education IRA for his 8-year-old son David for 10 years beginning in 1998. In 2008, when the account balance is $8,000 (including $3,000 in earnings), David withdraws the entire $8,000 balance to pay part of his $10,000 qualified higher education expenses. David's 2008 taxable income does not include the $3,000 in earnings from the education IRA account.
But please remember that if a beneficiary excludes any amount of an education IRA distribution for a tax year, neither a HOPE nor a Lifetime Learning Credit may be claimed for that beneficiary for that year. We'll discuss the interrelationship between these credits and the education IRA in more detail next week.
If distributions from an education IRA exceed qualified education expenses, there is an additional tax of 10% of the taxable amount. But this 10% additional tax does not apply to distributions:
- Made after the death of the beneficiary
- Attributable to the beneficiary's disability; or
- Made on a distribution that can be included in income solely because an election is made to waive the income exclusion (such as to take the HOPE or Lifetime credit as opposed to the tax-free treatment of the education IRA).
Example: Using the Dad and David example above, let's say that David decides to take his $8,000 education IRA distribution and go to Europe in 2008. David doesn't incur any qualified education expenses for 2008. In this case, David would have to report income of $3,000 (the earnings on the education IRA), and would also have to pay an additional tax of $300 (10% of the taxable amount).
The beneficiary must use the education IRA funds within 30 days after the beneficiary turns 30. Any funds remaining after that time will be deemed distributed to the beneficiary (whether actually distributed or not), and the earnings will be subject to regular income tax and the additional 10% tax if not used for qualified education purposes.
But you should know that an education IRA distribution not used for qualified education expenses is not taxable to the extent that it is rolled over into another education IRA for the benefit of the beneficiary, or for the benefit of another member of the beneficiary's family. For this purpose, a family member includes: a son, daughter, or a descendant of either; a stepson or stepdaughter; a brother, sister, stepbrother or stepsister; a father, mother or an ancestor of either; a stepfather or stepmother; a nephew or niece; an uncle or aunt; and a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. It would also include the spouse of any of those persons. But, the new beneficiary of this rollover distribution must be under age 30 on the date of the rollover.
Example: Sam has not used all of his education IRA and will soon turn 30 years old. His account has a balance of $25,000, including earnings of $14,000. Sam doesn't want to take the education IRA as a distribution and pay the normal income tax and additional 10% tax on the $14,000 in earnings. Instead, Sam decides to roll over this $25,000 education IRA to his nephew Jim, who is only 4 years old. Jim now has a BIG head start on his college savings.
For the purposes of the education IRA, "higher education expenses" include expenses for tuition, fees, books, supplies, and equipment required for the beneficiary's enrollment or attendance at an "eligible educational institution." While there is no requirement that the beneficiary be enrolled on a half-time or greater basis to be considered qualified education expenses, if the beneficiary IS enrolled on a half-time or greater basis, some of the room and board expenses may also be considered a qualified education expense.
Again, as with most tax issues, there are other technical requirements that space does not allow us to deal with here and now. So before you begin your education IRA, make sure that you've done your research. Next week we'll look at how all of these credits, deductions, and potential tax-free income work together.
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- 10/30/98
