Education IRAs: should you bother?: for many parents, the complications outweigh the rewards

Kiplinger's Personal Finance Magazine, Jan, 1998 by Stephanie Gallagher

When Congress came up with the education IRA, the idea was to give parents an incentive to save, rather than spend, the new $500-a-year tax credit ($400 in 1998) for each child under age 17. Each year, assuming your income isn't too high, you can put up to $500 into an education IRA for any child under age 18; if the money is withdrawn to pay for college expenses, the earnings are tax-free.

It's hard to sneer at a well-intentioned tax break for college saving. But restrictions on education IRAs, combined with other twists in the new tax law, make them more trouble than they're worth for many parents.

For starters, the $500-a-year cap on contributions is skimpy. Even if you started an account for a newborn, contributed the maximum every year and earned 10% annually, you'd still have only $22,800 by the child's freshman year -- an amount likely to cover at best a semester's expenses. The limit means that you'll probably need to invest in other savings vehicles, adding to the number of accounts you'll have to track.

Worse, each year you tap an education IRA for college expenses, you forfeit the opportunity to take a Hope Scholarship credit (worth up to $1,500 a year in the first two years of college) or a Lifetime Learning credit (worth up to $1,000 a year for each additional year of postsecondary education through 2002, and $2,00 a year thereafter). In addition, the account could be considered the child's asset under financial-aid formulas, which would reduce the amount of financial aid you receive.

An education IRA may be worthwhile, however, if you doubt you'll qualify for those credits -- or for financial aid -- because your income will be too high. You can claim either credit in full if your adjusted gross income in your child's college years is less than $80,000 on a joint return or $40,000 on a single return -- amounts that will rise with inflation starting in 2002. Currently, the credits disappear completely at $100,000 for joint filers and $50,000 for singles.

The next hurdle is a separate set of income-based restrictions on who can fund an education IRA. You're eligible to make a $500 contribution if your current income is less than $150,000 on a joint return or $95,000 on a single return. (You can make partial contributions with up to $160,000 and $110,000 AGI, respectively, but then you're really talking peanuts.) The income limits apply to whoever funds the account, not necessarily the beneficiary's parent. But be careful that Grandma and Aunt Minnie don't inadvertently overfund your child's account. Only $500 per beneficiary can be contributed in a single year, and there's a 6% penalty on excess contributions.

If you do fund an education IRA, plan to use all the savings in a single year. That way you can take the tax credits in other years.

What if you fund an education IRA, anticipating that you won't be eligible for tax credits, and then qualify after all when the time comes? You can keep the account until the beneficiary is 30 years old, but if it isn't used for higher-education expenses by then, the beneficiary must withdraw the money and pay income tax on the earnings, plus a 10% penalty. To avoid a taxable distribution, the account can be transferred to a sibling, or even the beneficiary's child. The new law isn't dear on who would control the money, but it's likely to be the beneficiary -- who could choose to stiff Sis, pay the tax and take a trip to Tahiti. OTHER SNAGS. The new law also prohibits funding an education IRA in the same year you contribute to a state-sponsored prepaid tuition program. And some new programs look pretty attractive. New York's forthcoming college-savings plan will allow parents from any state to contribute up to $5,000 a year to a federal-tax-deferred account that can be used at any college in the country (New York residents avoid state tax on the earnings). "There are certainly a lot more opportunities in this plan than in the education IRA," says Philip Johnson, a Clifton Park, N.Y., financial planner.

Finally, your investment choices for an education IRA may not be as broad as you'd like. Because the contribution limit is so low and small accounts are costly to administer, some mutual fund and brokerage companies are reluctant to accommodate them. Even those that do may restrict the number of funds they offer. AN ALTERNATIVE PLAN. If you'll have a child in college when you reach age 59 1/2, you may want to sidestep the education IRA in favor of a Roth IRA for college savings. You can contribute up to $2,000 a year to a Roth IRA, and once the account has been open for at least five years and you are 59 1/2 or older, you can withdraw as much as you want, tax- and penalty-free. This idea is especially appealing if you have other tax-sheltered retirement savings, such as a 401(k) plan or Keogh plan. Younger parents can withdraw Roth contributiom tax- and penalty-free for college expenses (or any other purpose). But if they dip into earnings, that amount will be taxed. At any age, though, as long as the money is used for college bills, the 10% early-withdrawal penalty does not apply. stomers with