Death & Taxes

The Education IRA Is A-Changin'

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By Roy Lewis
October 12, 2001

An Education IRA (which really isn't an IRA at all, in the true sense of the word) is a custodial account or trust, usually maintained by a bank or financial organization, exclusively for the purpose of paying qualified education expenses of the designated beneficiary. Education IRAs must accept contributions only in cash (yes, that means checks, also). Distributions from an Ed IRA are tax-free.

The Economic Growth and Tax Relief Reconciliation Act of 2001 will introduce many changes to the Education IRA rules beginning in 2002. In fact, one of those changes includes the name: In memory of the late Sen. Paul Coverdell (R-Ga), the name of has been changed to the Coverdell Education Savings Account (or Coverdell ESAs). But, with all due respect to the late Senator, we'll continue to use the old name until the new name catches on. The issues surrounding the Education IRA are confusing enough.

Many folks found the rules surrounding the Ed IRA so restrictive (especially when dealing with a maximum $500 contribution per child per year) that the Ed IRA had quickly fallen out of favor soon after it was introduced in 1997. But the new laws might revive much of the interest in the Ed IRA.

Here are the current rules along with the major changes that will take place in 2002:

Maximum contribution

  • 2001 and before: $500 per child per year
  • 2002 and beyond: $2,000 per child per year

Timing of contribution

  • 2001 and before: Contributions are required to be made by Dec. 31 of the year of the contribution.
  • 2002 and beyond: You'll have until April 15 of the following year in order to make contributions for the prior year.

Age limitations

  • 2001 and before: Contributions can't be made after the child reaches age 18. No provisions for "special needs" children.
  • 2002 and beyond: Contributions can't be made after the child reaches age 18, unless the child is deemed to be a "special needs" child, as defined by IRS regulations.

Required distributions

  • 2001 and before: Distributions are required to be made by age 30. No provisions for "special needs" children.
  • 2002 and beyond: Distributions are required to be made by the time the child turns age 30, unless the child is deemed to be a "special needs" child, as defined by IRS regulations.

Definition of qualified education expenses

  • 2001 and before: Primarily eligible for higher education expenses only. No provisions for elementary or secondary school education expenses.
  • 2002 and beyond: Virtually all reasonable expenses for both higher education and elementary/ secondary education will be eligible for the tax-free treatment afforded Education IRA distributions. This is a huge change, and we'll discuss it in greater detail below.

Interaction with HOPE Credit and Lifetime Learning Credit

  • 2001 and before: If any Ed IRA funds were used to pay qualified education expenses, neither the HOPE nor the Lifetime Learning Credit could be claimed in that same tax year.
  • 2002 and beyond: If Ed IRA funds are used to pay qualified education expenses, the HOPE or Lifetime Learning Credit is still allowed for that tax year, as long as the expenses paid by the Ed IRA are not duplicated as qualifying for either credit.

Adjusted gross income phase-out limitations

  • 2001 and before: The contribution limit is phased out ratably for contributors with a modified adjusted gross income between $95,000 and $110,000 for single persons and between $150,000 and $160,000 for joint filers.
  • 2002 and beyond: The contribution limit is phased out ratably for contributors with a modified adjusted gross income between $95,000 and $110,000 for single persons and between $190,000 and $220,000 for joint filers. (Note that the contributions limits have remained the same for single folks, but has been increased for married folks.)

New definition of qualified education expenses
As noted above, there have been some massive changes to this definition. The Ed IRA isn't just for college expenses any longer; it can be also used for elementary and secondary education expenses. Under the new law, "qualified elementary and secondary education expenses" are defined as:

  • Expenses for tuition, fees, academic tutoring, special needs services (in the case of a special needs child), books, supplies, and other equipment that are incurred in connection with enrollment or attendance of the child as an elementary or secondary school student at a public, private, or religious school.
  • Expenses for room and board, uniforms, transportation, and supplementary items and services (including extended-day programs) that are required by a public, private, or religious school.
  • Expenses for the purchase of any computer technology or equipment or for Internet access and related services if the technology, equipment, or services are to be used by the child and the child's family during any of the years that the child is in school. However, there is a specific exclusion for any computer software designed for sports, games, or hobbies unless the software is educational in nature.

"Qualified education expenses" also include any distributions taken from an Education IRA and contributed to a qualified tuition program on behalf of a child. Such Education IRA distributions will be tax-free.

New law, same loopholes
There is a massive loophole that Congress apparently knew about but did nothing to close. It has to do with gifting money to the child when the contributor is over the income limitation limits. Let's look at an example:

Grandpa, a single person, wants to establish an Education IRA for little Johnny. But Grandpa's AGI is $130,000. His maximum contribution to little Johnny's education IRA account would be... ahem... ZERO, because of the income limitation rules.

But note that, unlike other IRAs, a person can make a contribution to an Education IRA even if that person has no compensation income for that tax year. This being the case, there is no reason that Grandpa can't make a $500 gift to little Johnny. Johnny can then open his own Education IRA account for the full $500, since Johnny is well under the income limitations.

New law, same rules
While the new law made many changes, some of the old rules relative to the Ed IRA still apply.

If distributions from an Education IRA exceed qualified education expenses, there is an additional tax of 10% of the taxable amount. But this 10% additional tax does not apply to distributions 1) made after the death of the beneficiary, or 2) are due to the beneficiary's disability.

Another rule that is unchanged has to do with distributions by the time the child reaches age 30. The child must have used up the Education IRA funds by the time 30 days have passed following his or her 30th birthday. Any funds remaining after that time will be deemed distributed to the beneficiary (whether actually distributed or not), and the earnings will be subject to regular income tax and the additional 10% tax if not used for qualified education purposes. (This restriction has been lifted in 2002 for a "special needs" child.)

But remember that the "rollover" rules still apply. An Education IRA distribution not used for qualified education expenses is not taxable to the extent that it is rolled over into another Education IRA for the benefit of the beneficiary, or for the benefit of another member of the beneficiary's family. For this purpose, a family member includes: a son, daughter, or descendant of either; a stepson or stepdaughter; a brother, sister, stepbrother, or stepsister; a father, mother, or an ancestor of either; a stepfather or stepmother; a nephew or niece; an uncle or aunt; and a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. It also includes the spouse of any of those persons. The new beneficiary of this rollover distribution must be under age 30 on the date of the rollover.

The financial aid trap
Lower- and middle-income parents who expect their child will be eligible for financial aid in college should think twice about taking advantage of Education IRAs for college savings. This is another rule that hasn't changed about the Ed IRA. If you think that you might be caught in this trap, read "Education IRAs: The Financial Aid Trap."

Big changes, big opportunities, but still some big restrictions. Have the rules surrounding the Ed IRA changed enough for you to get interested in it again? You'll have to look at all of the pros and cons and make your own decision. We hope that the information presented above will allow you to do just that.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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