EDUCATION IRAS

With the recent changes in the federal tax law, education IRAs have become a more attractive choice to help fund education than they used to be. Education IRAs are essentially a tax-deferred way of growing money to help pay for a child’s higher education. The main attraction to these accounts is that as long as the money is used for qualifying expenses, which we discuss, the distributions are tax-free.

Under the old tax law, contributions were limited to $500 per year. Considering the fact that this money was going to be used for college education, that $500 limit was pretty paltry. However, with the change in the law, the new limit is $2000 per year, which is more reasonable. Unlike traditional and Roth IRAs, the person benefiting from the education IRA doesn’t need to have any earnings. This works especially well if the education IRA is for a child whose parents have been phased out from being able to contribute.

There are limitations to the amount of income the donor can earn and still make contributions. For those who file as single on their taxes, they can have a maximum adjusted gross income of between $95,000 and $110,000 until the ability to contribute is completely phased out. For those filing as married, the maximum adjusted gross income is now between $190,000 and $220,000 (double the limitations for single filers) before the contribution is phased out. Therefore, for families who want to make contributions to education IRAs but fall outside the AGI limits and are ineligible to make contributions, it makes sense to encourage the children to make contributions. Also, any contribution to an education IRA is not counted with any traditional or Roth IRA contributions. They are considered to be completely separate.

Contributions to education IRAs are done on an after-tax basis and cannot be deducted on your federal income tax return. The money will grow tax-deferred and then all qualified distributions will be tax-free. In the past, the only distributions that qualified to be tax-free were any postsecondary tuition costs, fees, books, supplies, and equipment. In addition to those, this year, the government has added many other types of qualifying expenses. Now, the definition includes expenses from elementary or secondary schools, certain types of room and board costs, uniforms, computers, and extended day programs costs.

There are some cases where the amount of money that can be distributed tax-free is reduced by any nontaxable scholarships, fellowship grants, and educational assistance allowances. The change in the tax law has now allowed for the coordination of the benefits from the education IRA and the HOPE and Lifetime Learning credits for education expenses, so that there is no dual tax benefit for the same expenses.

As with traditional IRAs, there is a required distribution age for any unused portion of the education IRA. Additionally, unused money may be rolled over into another education IRA for another family member. A rollover may be made as long as the original owner of the education IRA is under the age of 30. However, if the rollover isn’t done and the beneficiary reaches 30 years of age, the remaining portion of the IRA must be distributed to the beneficiary. This money will then be taxed at the individual’s ordinary income rate, including a 10-percent early withdrawal penalty. This, of course, seems unfair. After all, the government is requiring you to take out the money that hasn’t been used; yet they are penalizing you because it is technically a premature distribution. This is why it’s important either to use the entire amount, or roll over any unused portion.

Because the limit on annual contributions to an education IRA is $2000, there is no worry about triggering any gift tax to the recipient. But, when rolling over an unused education IRA, there is potential for gift tax consequences. If the rollover is made to a family member of the same generation (i.e., brother to sister, etc.), there is no taxable gift. However, if the rollover is made from one generation to the next, the gift tax could apply. As long as the education IRA rollover is $11,000 or less, there would be no gift tax. Rollovers that exceed $11,000 would be subject to the tax.