Education IRA

Education IRA

Host : Now wasn't there something about an education IRA in the new law?

David : Right. The education IRA is similar to the state prepaid tuition program. However, the education IRA offers more freedom in some respects than a state-sponsored program.

They both allow for tax-free growth in earnings, but the money in your education IRA can be used at any college, not just a school in your state.

Host : So what's the connection with an IRA? Can you save for retirement with these?

David : No, absolutely not. This is another oxymoron politicians have given us.

Normally, an IRA stands for an Individual Retirement Arrangement. But you can't use an education IRA for retirement.

The money in an education IRA must be spent on the beneficiary's education by the age of 30, or there's a 10 percent penalty tax.

I guess they used the term "IRA" because people are familiar with the term and they understand the tax-free growth in earnings it offers. Also, as a matter of law, many of the technicalities in traditional IRAs and education IRAs are the same.

Host : In the traditional IRA, you could deduct the amount you put into your IRA from your current income. Is that true with the education IRA?

David : No. You can only put after-tax dollars into an education IRA. And there are other differences from a traditional IRA.

Normally, you can contribute only earned income to an IRA. So a 5-year-old child with no job can't contribute to a traditional IRA, but a 15-year-old baby sitter can put her earnings into an IRA.

But an education IRA is different. Here, a parent, a grandparent, or even a complete stranger can contribute a total of $500 to be held in trust by an education IRA for the child's benefit.

So if parents or others contributed $500 per year from birth and the money earned 8 percent, a child could have over $22,000 for college by age 18.

Host : And all that money can be used tax-free for college, right?

David : Right. But after age 18, no further contributions can be made to the education IRA. Also, there's a phase-out for contributions. This phase-out begins at $95,000 for single filers, and $150,000 for joint filers.

Further, you can't combine the Hope credit, the lifetime learning credit and education IRA withdrawals in the same year. In a single year you can use one, and only one, of the three.

Host : So what's a good strategy here?

David : This can be complex so it pays to plan out your cash flow for your college years, because there's several things to consider.

Generally, I'd recommend using the Hope credit the first two years.

Also, if you're applying for financial aid, you want to keep your income low for at least the first two years of college so you can qualify for more aid.

So if you know you'll have to eventually take out a loan, you might want to take it out earlier because this won't increase your income, and thus won't deny you potential financial aid.

After using the Hope credit and securing any financial aid in the first two years, you can then tap into your education IRA which has been growing tax-free for two additional years.

After that's gone, you might want to finish up with the lifetime learning credit. Bear in mind, you only can use one of these per year.

Finally, after you've graduated and have found a great job that puts you into a high tax bracket, you can deduct any interest payments on outstanding education loans you may have built up.