Business Matters: A new way to save for education

By Kevin FitzGerald

My daughter has twin 8-year-old boys. She is a single mother and cannot afford to put much away for their college education. I would like to help a little, but I’m not sure what to do.

— A.M.R., New York

The headlines are staggering — college costs are up; financial assistance is down. You want what is best for your children or grandchildren, but you worry that your regular savings will not cover the ever increasing expense of higher education.

Now, thanks to recent legislation, there is help available — the Education IRA. Modeled on the individual retirement account, the Education IRA is a savings vehicle designed to help investors prepare for the future higher education expenses of children, grandchildren or any child under the age of 18.

Like a traditional IRA, the earnings on the Education IRA contributions are not taxable while they are held in the account. However, the Education IRA has several important features that distinguish it from a traditional IRA and taxable savings accounts:

€ contributions are not tax deductible, but earnings grow tax deferred;

€ withdrawals are tax free when used for post-secondary education expenses such as tuition, fees, books, supplies, equipment and room and board (for students in attendance on at least a half-time basis);

€ any remaining balance in the Education IRA may be distributed or rolled over to an Education IRA for another eligible family member. However, any money that is not used for eligible expenses and is then withdrawn would be subject to ordinary income tax, plus an additional 10 percent penalty.

With the new Education IRA, up to $500 per year can be contributed on behalf of a child under 18 and there is no limit on the number of children for whom you may contribute.

To be eligible to open an account, both the contributor (the account holder) and the beneficiary must meet certain eligibility requirements. Following are details:

Contributor Eligibility

An Education IRA is the only type of IRA that does not require that you have earned income to fund it. Therefore, contributions may be made even if you only have investment or pension income, making it an excellent way for retired grandparents to assist the funding of their grandchildren’s education.

If your adjusted gross income (AGI) is less than $95,000 if you are a single taxpayer or less than $150,000 if you are a married taxpayer filing jointly, you may make the full $500 contribution on behalf of a beneficiary. If your AGI is between $95,000 to $110,000 (single) or $150,000 to $160,000 (married filing jointly), you may make a partial contribution. You are not eligible to make a contribution if your AGI exceeds these limits.

Beneficiary eligibility

While the contributor eligibility requirements are less stringent for Education IRAs, a new level of eligibility applies that does not exist with a traditional IRA — beneficiary eligibility. To open an Education IRA, you must be sure of the following:

€ the beneficiary is under 18 years of age when receiving contributions;

€ you make no contribution to the beneficiary’s account in years where any amount has been contributed to a state-run prepaid tuition program on his or her behalf;

€ if more than one person is funding an Education IRA for a beneficiary, it is important that the contributions be coordinated so that no more than $500 be contributed annually from all sources to the same beneficiary.

Changing Beneficiaries

In the event that the original beneficiary does not completely use his or her Education IRA, the unused balance can be rolled over to another eligible family member’s Education IRA. In the case of a rollover, the $500 annual limit does not apply.

For More Information

Of course, building a higher education fund requires some foresight and careful planning — essentially a strategy that allows you to both control the timing and taxability of your investments. Talk to an investment executive for more details about the potential benefits of establishing an Education IRA.

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The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

Kevin FitzGerald is first vice president-investments at Paine Webber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 423-3381.