Beginning in 1998, the Taxpayer Relief Act of 1997 (TRA '97) created a new type of savings account called an Education IRA. An Education IRA is an education savings account that is used to help individuals save for qualified higher education expenses of a designated beneficiary (child). The Education IRA offers two important tax advantages:
#1 Tax-Free Distributions
#2 Tax-Free Earnings
Contributing to an education IRA for a child is a good way to help pay for the child's education expenses after high school.
Beginning in 1998, you can make a cash contribution of up to $500 per year to an Education IRA for a designated beneficiary. Education IRA contributions are not deductible, but you get the full benefit of tax-free distributions and earnings!
The contribution is made by the contributor (e.g., parent or grandparent) for a designated beneficiary (e.g., child or grandchild) under age 18. Contributions may be made even if the contributor makes a contribution to a traditional IRA or a Roth IRA.
Most individuals are eligible to make a $500 annual contribution to an education IRA for each child. However, individuals whose modified adjusted gross income (MAGI) exceeds certain levels will not be allowed to contribute as much per child.
For individuals with MAGI between $95,000 and $110,000 for single filers ($150,00 and $160,000 for joint filers) the annual $500 contribution limit is phased out using a prorated formula, as shown in the chart below. For example, a married couple filing jointly whose MAGI is $155,000 is permitted to make a contribution of $250 for each child.
Contributions Not Allowed
Single individuals with MAGI of $110,000 and over and married individuals who file jointly, with joint incomes of $160,000 and over, may not make an Education IRA contribution for anyone.
Contributions cannot be made on behalf of a child for any tax year in which any contributions are made by anyone to a qualified state prepaid tuition program for the same child, regardless of the contributor's MAGI.
Contributions cannot be made after the child attains age 18. Annual contributions are limited to $500 per beneficiary, not $500 per contributor.
Depositing Money in an Education IRA
You do not have to contribute to an Education IRA every year. Also, you do not have to contribute $500 each year for each child; however, the more you contribute, the more that is available for each child's education expenses.
Qualified Education Expenses
Qualified education expenses include expenses of an individual, regardless of whether the beneficiary is enrolled at an eligible educational institution on a full-time or part-time basis. Such expenses include post-secondary tuition, fees, books, supplies, and equipment. Room and board expenses are qualified expenses if the student is enrolled at an eligible education institution on at least a half-time basis. Distributions that do not exceed the qualified education expenses are completely tax-free.
Taxation of Distributions
If the qualified education expenses are less than Education IRA distributions, all or a portion of the earnings will be taxable to the designated beneficiary under a prorated formula. Additionally, the taxable portion be subject to a 10% penalty unless the distribution is made after the death of the designated beneficiary, attributable to the designated beneficiary's being disabled, or is less than or equal to the amount of a scholarship or tax-free education assistance received by the designated beneficiary. Thus, an individual will not be penalized if the funds are not needed for educational expenses because the beneficiary received a scholarship.
Rollovers/Designated Beneficiary Changes
An Education IRA is flexible in that it allows for the tax-free rollover to an Education IRA for a new designated beneficiary. The new beneficiary must be a member of the same family of the current designated beneficiary. However, such rollovers are permitted only once per year. In such cases the funds may be used for higher education expenses of the new designated beneficiary.
The biggest advantage of an Education IRA is that the earnings are tax-free if used for qualified education expenses. In the following chart, we've assumed an annual deposit of $500 on the first day of each year for the first 18 years and an annual percentage yield of 7%, with all earnings reinvested in the account.
Starting Your Education IRA
Starting an Education IRA is easy. We'll provide you with forms. And, we're here to answer your questions.
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