A reader writes: “Can a grandparent contribute $500 to an Education IRA for a grandson, or is it just the parents who can contribute?”
Anybody will be able to contribute, whether a parent, grandparent, uncle, cousin, older sibling, other relative or somebody not even related to the child.
Whether contributing makes all that much sense is another matter, given the many quirks in the law and other alternatives.
The Taxpayer Relief Act of 1997, which allows the Education IRAs to be set up beginning next year, says eligible taxpayers can contribute up to a maximum of $500 a year for any beneficiary under the age of 18.
That’s $500 per child, so parents with four children, for example, can set up four Education IRAs with $500 each.
And more than one person can contribute to the same Education IRA–say a parent and grandparent each kicks in $250 one year.
But again the total annual contribution cannot exceed $500 per child, less than what is likely needed to pay for college.
“The $500 limit is disappointing,” said Joan K. Crain, second vice president of Northern Trust Bank in Ft. Lauderdale, Fla.
Another negative is that you can’t contribute to the Education IRA in a year in which any payments are made on behalf of the child to a state prepaid tuition program.
And, as far as tax breaks are concerned, the Education IRA doesn’t seem nearly as attractive as the new HOPE scholarship credit, which can go as high as $1,500 per year the first two years of college, or the lifetime learning credit of qualified tuition expenses, which has a ceiling of $1,000 a year per taxpayer (not per student) from 1998 to 2002, and $2,000 thereafter.
And you can’t have your cake and eat it, too–you must choose just one of the three tax breaks per year per child.
Confused? Who can blame you?
All of these programs have different eligibility rules and limits as to what is covered. So the Education IRAs, as Crain said, “are not something to be totally dismissed.”
The person making a contribution to an Education IRA must meet certain income limits–no more than $110,000 of modified adjusted gross income for single taxpayers and $160,000 for couples filing jointly.
Singles with incomes between $95,000 and $110,000 and couples with incomes between $150,000 and $160,000 can still contribute, but the amount is reduced as income rises.
The term Education IRA, although widely used, is really a misnomer. IRA stands for individual retirement account, and Education IRAs have nothing to do with retirement. It is simply a way to save for a child’s college education and get some tax breaks.
The contributions themselves are not tax deductible, but no tax is paid on the earnings or withdrawals up to the amount of qualified higher education expenses paid by the child in the year the money is taken out.
Depending on how much your investment grows, this tax break after several years may or may not be more attractive than the immediate scholarship or lifetime learning credits you could claim.
Credits reduce your tax bill dollar for dollar, but an income “exclusion” from an Education IRA withdrawal lowers only your taxable income.
How much you save on taxes then depends on what your tax bracket is.
Qualified expenses for Education IRA withdrawals include tuition and fees and books and, provided the student is enrolled at least half-time at an eligible institution, room and board.
Because the money is intended to be used for educational expenses, any amount not spent by the time the beneficiary reaches 30 must be taken out, and taxes paid on any earnings, plus a 10 percent penalty.
But both the tax and penalty can be avoided if the money is rolled over into another Education IRA for the benefit of another child in the original beneficiary’s family, such as a younger sibling or even the beneficiary’s own child.
