The Educational IRA allows for annual contributions of up to $2000 per year per child who is under 18 years old. While the contributions are not deductible, all of the accumulated earnings will eventually be tax-free if the distributions received during the year do not exceed the payments for "qualified educational expenses". Generally, tuition and books for post-high school education qualify for the exclusion. In addition, room and board generally qualifies if the student is enrolled on at least a half time basis. However, total qualifying expenses are reduced by scholarships or other tax-free grants that the student receives. Finally, the tax benefits are not limited to college expenses. Most post-secondary vocational schools (e.g. beautician school) also qualify.
Generally, annual distributions which exceed the "qualified educational expenses" discussed above are tax-free to the extent of the original contributions. Distributions of accumulated income are subject to both income taxes and a 10% penalty.
Contributions are limited (or totally prohibited) from a contributor whose income for the year exceeds $95,000 ($150,000 on joint tax returns). However, a "contributor" is not limited to the child's parents. A relative, friend, or even the child can be the "contributor" assuming that the parent's income is too high. However, the IRS could treat the parent as the contributor, if the other person was acting under the parent's direction and control.
If the child does not use all of the funds in the IRA for educational expenses, there are a few tax saving choices available. First, part or all of the IRA account can be transferred tax-free to Educational IRAs of certain family members such as a brother or sister. Second, the funds could remain in the IRA and accumulate additional tax deferred investment income. However, at age 30, the entire balance must be distributed to the beneficiary. Unless the beneficiary can come up with enough qualified educational expenses for the year, he/she will pay income tax and a 10% penalty on the portion of the distribution that represents accumulated income.
The main advantage to Educational IRAs over other tax advantaged plans involves costs, especially when the savings goal is relatively modest (say no more than $5,000). Many financial institutions offer Educational IRAs with either no fees or very small fees. For more aggressive goals, I feel that there are better ways to save for your children's college expenses than through an Educational IRA.
There are two major disadvantages to Educational IRAs:
State sponsored college savings plans (also called "529 Plans") may not be as much of a problem. For information on 529 Plans, press here.
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