Tax Law Limits Contribution To $500 For Education IRA

A new, little-advertised feature of the tax law this year is the Education IRA. Here's how this little baby IRA works.

Starting in 1998, you can contribute up to $500 per year to an IRA established for the benefit of a child who will eventually attend college. Sounds simple, right? No way. The establishment of this new IRA raises nearly as many questions as there are picky rules accompanying this tax "break."

What is the tax benefit of an Education IRA? Unlike a regular IRA, there is no current deduction for contributions to an Education IRA. The earnings on the account, however, accumulate tax-free, and all money comes out of the account tax-free when it is used for the college education of the designated beneficiary.

Who can make a contribution to an Education IRA? The Education IRA isn't just for parents. Anyone can set up an Education IRA for a child. That means grandparents, cousins, well-meaning neighbors, friends of the family, siblings, and so on. The person contributing to the IRA must have adjusted gross income at least as high as the contribution. In simpler terms, if you want to contribute $100 to an Education IRA for your niece, you have to report income on your tax return of at least $100.

How do I set up an Education IRA? You must set up your Education IRA through a financial institution. You can't just open a savings account and call it an Education IRA. Contact your bank or broker, the same entity you would contact to set up any other type of IRA.

How much can I contribute each year? You can contribute up to $500 each year to an Education IRA. Contributions must be made in cash. Contributions to Education IRAs do not count towards your annual limit of $2,000 for contributions to regular or Roth IRAs. There is a phase-out for high-income taxpayers. If you are single, the opportunity to contribute to an Education IRA begins to phase out as your adjusted gross income exceeds $95,000, and the right to contribute phases out completely if your AGI exceeds $110,000. These amounts increase to $150,000-$160,000 for taxpayers who are married filing jointly. Can I set up an Education IRA for more than one beneficiary? There is no limit to the number of Education IRAs you can create. If you have 12 grandchildren, nieces, and nephews, you can set up an Education IRA for each child and make an annual contribution of up to $500 to each IRA (provided your income is at least as high as the total amount you contribute).

Who counts as an eligible beneficiary? You may make contributions to an Education IRA for any child who is 18 years old or younger. As soon as the child's 18th birthday arrives, you must stop making contributions.

Can more than one person contribute to an Education IRA for the same child? Yes. There is no limit to the number of Education IRAs that can be created for one child. The total amount, however, that can be contributed to all of the Education IRAs for the same child may not exceed $500 per year.

What happens when money is withdrawn from an Education IRA? Money in an Education IRA account is withdrawn tax-free and must be used for the costs of higher education of the beneficiary. The beneficiary can be a full-time or part-time student. To the extent that money is withdrawn from an Education IRA and not used appropriately, the amount that represents earnings of the account (e.g., interest or dividends) is subject to income tax and a 10% penalty for the beneficiary.

What if I set up an Education IRA for my grandson and he decides not to go to college? At any time, you can choose to rollover the Education IRA to another beneficiary in the same family and the same generation without adverse tax consequences. So, if your grandson chooses not to attend college, you can make his sister the beneficiary on the account, and not have to pay any tax.

Is there a time limit for withdrawals? There is an age limit on withdrawals from an Education IRA. The beneficiary of the Education IRA must use the money by the time he turns 30, or the account turns into a pumpkin (and, trust me, it's not a pretty sight). At that time, all money left in the account, to the extent that it represents untaxed earnings, gets included in the gross income of the beneficiary, is subject to income tax, and is also subject to a 10% penalty.

copyright © 2000 Gail Perry - Fun with Taxes


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