Educational IRA

If the costs of higher education are concerning you, some relief in on the way courtesy of the Taxpayer Relief Act of 1997. Beginning in 1998, taxpayers can make nondeductible contributions of up to $500 per beneficiary (until the beneficiary reaches age 18) to a tax-exempt Education IRA created to pay the costs of the beneficiary's higher education.

The $500 annual contribution must be paid in cash and ceases when the beneficiary reaches age 18. The $500 annual contribution limit does not apply to rollover contributions. The $500 annual contribution limit for an Education IRA is phased out for single contributors with modified adjusted gross income (AGI) between $95,000 and $110,000, and for married taxpayers with modified AGI between $150,000 and $160,000.

An Education IRA must be created exclusively to pay the higher education expenses of the beneficiary, i.e., tuition, fees, books, supplies and equipment, as well as room and board (as long as the student is enrolled on at least a half-time basis). Elementary and secondary school expenses are not included.

The earnings on the amounts in the Education IRA are tax-free. Distributions from an Education IRA are also tax-free. However, distributions exceeding the higher education expenses of the beneficiary are includible in the distributee's gross income and are subject to a 10% penalty tax. Contributions may not be made to an Education IRA for a beneficiary during the same year in which contributions are made to a qualified State tuition program on behalf of the same beneficiary.

For federal estate and gift tax purposes, any contribution to an Education IRA will be treated as a completed gift of a present interest from the contributor to the beneficiary at the time of the contribution. In addition, annual contributions are eligible for the $10,000 gift tax exclusion. Distributions from an Education IRA are not treated as a taxable gift.

Tax-free (and penalty-free) rollovers of amounts paid or distributed from an Education IRA are permitted to the extent that the amount is paid into another Education IRA for the benefit of the same beneficiary or a member of the family of the beneficiary within 60 days of the payment or distribution. Such rollover may occur only once during a 12-month period. Redesignating the named beneficiary is not treated as a distribution as long as the new beneficiary is a member of the old beneficiary's family. Transfers due to a change in the designated beneficiary or rollovers to the account of a new beneficiary are not treated as a taxable gift from the old beneficiary to the new beneficiary if the transfer is within the same generation. Transfers between generations are considered taxable gifts.

In addition to the Education IRA, taxpayers can make penalty-free withdrawals from their individual retirement plans for the higher education expenses of the taxpayer, the taxpayer's spouse, or any child or grandchild of the taxpayer or the taxpayer's spouse.

Of some note is the fact that the new law does not define who can contribute to an Education IRA on behalf of a beneficiary. Nor does it specify who the beneficiary must be. Thus, it is possible that any relative, friend, or even the beneficiary himself or herself could establish and contribute to an Education IRA. Further, the new law does not require the contributor to have income in order to contribute. Accordingly, there is the potential for many different contributors (family or friends or the beneficiary) to each set up an Education IRA for the beneficiary. Consequently, it is possible that the amounts in the various Education IRAs could pay for a few years at an expensive school or all four years at a less expensive school.

Finally, at this point in time, there is no requirement in the new law itself that the Education IRA be terminated when the beneficiary reaches a certain age. However, that may change in the future.

If you are interested in discussing the various aspects of the new Education IRAs and how they could affect you, please call my office so that we could set up an appointment.

Education IRA - Reprint of IRS Publicaiton

Beginning in 1998, you may be able to contribute up to $500 each year to an education individual retirement account (education IRA or Ed IRA) for a child under age 18. Contributions to an education IRA are not deductible.

Table 5. Education IRAs At a Glance

Do not rely on this chart alone. It provides only general highlights. See the text for definitions of terms in bold type and for more complete explanations.

Question Answer

What is an education IRA? An IRA that is set up to pay the

qualified higher education expenses

of a designated beneficiary.

Where can it be established? It can be opened in the United

States at any bank or other IRS-

approved entity that offers

education IRAs.

Who can an education IRA be set Any child who is under age 18.

up for?

Who can contribute to an education Generally, any individual

IRA? (including the beneficiary) whose

modified adjusted gross income for

the year is not more than $110,000

($160,000 for married taxpayers

filing jointly).

Any individual (including the child) can contribute to a child's education IRA if the individual's modified adjusted gross income (defined later) is not more than $110,000 ($160,000 on a joint return). The $500 maximum contribution for each child is gradually reduced if the individual's modified adjusted gross income is between $95,000 and $110,000 (between $150,000 and $160,000 on a joint return). See Contributions, later.

There is no limit on the number of education IRAs that can be established designating the same child as the beneficiary. However, total contributions for the child during any tax year cannot be more than $500.

Amounts deposited in the accounts grow tax free until distributed (withdrawn).

If, for a year, withdrawals from an account are not more than a child's qualified higher education expenses (defined later) at an eligible educational institution (defined later), the child will not owe tax on the withdrawals. See Distributions, later, for more information.

What Is an Education IRA?

An education IRA is a trust or custodial account created only for the purpose of paying the qualified higher education expenses (defined later) of the designated beneficiary of the account. To be treated as an education IRA, the account must be designated as an education IRA when it is created.

Trust requirements. The document creating and governing the trust must be in writing and must satisfy the following requirements.

1) The trust must be created or organized in the United States.

2) The trustee must be a bank or an entity approved by the IRS.

3) The trust must provide that the trustee can only accept a contribution that:

a) Is in cash,

b) Is made before the beneficiary reaches age 18, and

c) Would not result in total contributions for the tax year (not including rollover contributions) being more than $500.

4) Money in the account cannot be invested in life insurance contracts.

5) Money in the account cannot be combined with other property except in a common trust fund or common investment fund.

6) If the beneficiary dies, any balance in the account must be distributed to the beneficiary's estate within 30 days after the date of death.

Qualified higher education expenses. These are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. The term "qualified higher education expenses" means expenses for:

1) Tuition,

2) Fees,

3) Books,

4) Supplies, and

5) Equipment.

The term also includes:

1) Amounts contributed to a qualified state tuition program. (See Publication 525, Taxable and Nontaxable Income.)

2) Room and board if the designated beneficiary is at least a half-time student at an eligible educational institution. A student is enrolled at least half-time if he or she is enrolled for at least half the full-time academic workload for the course of study the student is pursuing as determined under the standards of the institution where the student is enrolled. Room and board is limited to:

a) The school's posted room and board charge for students living on-campus, or

b) $2,500 each year for students living off-campus and not at home.

Eligible educational institution. This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the Department of Education. It includes virtually any accredited public, nonprofit, or proprietary (privately owned profit-making) postsecondary institution.

Contributions

Any individual (including the designated beneficiary) can contribute to a child's education IRA if the individual's modified adjusted gross income for the tax year is less than $110,000 ($160,000 for married taxpayers filing jointly).

Contributions can be made to one or several education IRAs for the same child provided that the total contributions are not more than the contribution limit (defined later) for a tax year.

Table 6. Education IRA Contributions At a Glance

Do not rely on this chart alone. It provides only general highlights. See the text for definitions of terms in bold type and for more complete explanations.

Question Answer

Are contributions deductible? No.

Why should someone contribute to an It is a new tax benefit for

education IRA? families saving for higher

education costs.

What is the contribution limit? $500 each year for each child.

What if more than one education IRA The annual contribution limit is

has been opened for the same child? $500 for each child, no matter how

many education IRAs are set up for

that child.

What if more than one individual The contribution limit is $500 per

makes contributions for the same child, no matter how many

child? individuals contribute.

Can contributions other than cash No.

be made to an education IRA?

When can a taxpayer first contribute 1998.

to an education IRA?

When must contributions stop? No contributions can be made to a

child's education IRA after he or

she reaches age 18.

Qualified state tuition program. No contributions can be made to an education IRA on behalf of a beneficiary if any amount is contributed during the tax year to a qualified state tuition program on behalf of the same beneficiary.

Contribution limit. The maximum total contribution for each child is $500 for a tax year. This includes contributions to all the child's education IRAs from all sources other than rollovers. See Rollovers and Other Transfers, later.

Reduced limit for certain contributors. If your modified adjusted gross income is between $95,000 and $110,000 (between $150,000 and $160,000 for married taxpayers filing jointly), the $500 maximum contribution for each child is gradually reduced. If your modified adjusted income is $110,000 or more ($160,000 or more for married taxpayers filing jointly), you cannot contribute to anyone's education IRA.

Example. Paul, a single individual, had modified adjusted gross income of $96,500 for the year. For Paul, the maximum contribution for each child is reduced to $450, figured as follows.

1) $96,500 - $95,000 = $1,500

2) $1,500 ÷ $15,000 = 10%

3) 10% X $500 = $50

4) $500 - $50 = $450

Modified adjusted gross income. Your modified adjusted gross income for the purpose of determining the maximum contribution limit is the adjusted gross income shown on your return, increased by the following exclusions from your income.

1) Foreign earned income of U.S. citizens or residents living abroad.

2) Housing costs of U.S. citizens or residents living abroad.

3) Income from sources within:

a) Puerto Rico,

b) Guam,

c) American Samoa, or

d) The Northern Mariana Islands.

Other contribution rules. You can contribute only cash to an education IRA. You cannot contribute to an education IRA after the beneficiary reaches his or her 18th birthday.

Additional tax on excess contributions. A 6% penalty tax applies to:

1) Contributions that are more than $500 for the tax year for a designated beneficiary, and

2) Any contributions to the account if any amount is also contributed to a qualified state tuition program on behalf of the same beneficiary in the same tax year.

The penalty does not apply if the excess contributions (and any earnings on them) are withdrawn before the tax return for the year is due.

Distributions

In general, the designated beneficiary of an education IRA can take tax-free withdrawals to pay qualified higher education expenses. The withdrawals are tax free to the extent the withdrawal does not exceed the designated beneficiary's qualified higher education expenses. See Rollovers and Other Transfers, later.

Table 7. Education IRA Withdrawals At a Glance

Do not rely on this chart alone. It provides only general highlights. See the text for definitions of terms in bold type and for more complete explanations.

Question Answer

Is a withdrawal from an education Generally, the withdrawal is

IRA to pay for a designated tax-free to the designated

beneficiary's qualified higher beneficiary to the extent the amount

education expenses tax-free? of the withdrawal does not exceed

the designated beneficiary's

qualified higher education expenses.

After the designated beneficiary Yes. Also, certain transfers to

completes his or her education at members of the designated

an eligible educational institution, beneficiary's family are permitted.

may amounts remaining in the

education IRA be withdrawn?

Does the designated beneficiary No.

need to be enrolled for a

minimum number of courses to

take a tax-free withdrawal to

pay qualified higher education

expenses?

Tax treatment. The tax treatment of distributions (withdrawals) from an education IRA depends, in part, on the qualified higher education expenses that a designated beneficiary has in a tax year.

Distribution not more than expenses. Generally, a withdrawal is tax free to the designated beneficiary if it is not more than his or her qualified higher education expenses in a tax year.

Distributions more than expenses. Generally, if the total withdrawals for a tax year are more than the qualified higher education expenses, a portion of the amount withdrawn is taxable to the beneficiary.

The taxable portion is the amount that represents earnings that have accumulated tax free in the account. Figure the taxable amount as shown in the following steps.

1) Multiply the amount withdrawn by a fraction, the numerator of which is the total contributions in the account and the denominator of which is the total balance in the account before the withdrawal(s).

2) Subtract the amount figured in (1) from the total amount withdrawn during the year. This is the amount of earnings included in the withdrawal(s).

3) Multiply the amount of earnings figured in (2) by a fraction, the numerator of which is the qualified higher education expenses paid during the year and the denominator of which is the total amount withdrawn during the year.

4) Subtract the amount figured in (3) from the amount figured in (2). This is the amount the beneficiary must include in income.

Example. You receive a $6,000 distribution from an education IRA to which $10,000 has been contributed. The balance in the IRA before the withdrawal was $12,000. You had $4,500 of qualified higher education expenses for the year. Using the steps above, figure the taxable portion of your withdrawal as follows.

1) $6,000 X $10,000 ÷ $12,000 = $5,000

2) $6,000 - $5,000 = $1,000

3) $1,000 X $4,500 ÷ $6,000 = $750

4) $1,000 - $750 = $250 that you must include in income as withdrawn earnings not used for the expenses of higher education.

Additional tax. Generally, if you receive a taxable distribution, you must pay a 10% additional tax on the amount included in income.

Exceptions. The 10% additional tax does not apply to distributions that are:

1) Made to a beneficiary or to the estate of the designated beneficiary on or after the death of the designated beneficiary.

2) Made because the designated beneficiary is disabled (as defined in Publication 590).

3) Made because the designated beneficiary received a qualified scholarship excludable from gross income, an educational assistance allowance, or payment for the designated beneficiary's educational expenses that is excludable from gross income under any law of the United States to the extent the distribution is not more than the scholarship, allowance, or payment.

The 10% additional tax also does not apply to a distribution that is a return of an excess contribution. For the additional tax not to apply, the distribution must be made before the due date of the contributor's return (including extensions) and it must include any net income attributable to that contribution. That net income also must be included in the contributor's gross income for the tax year the contribution was made.

Rollovers and Other Transfers

Any amount withdrawn from an education IRA and rolled over to another education IRA for the benefit of the same designated beneficiary or certain members of the designated beneficiary's family is not taxable. An amount is rolled over if it is paid to another education IRA within 60 days after the date of the withdrawal.

Only one rollover per education IRA is allowed during a 12-month period ending on the date of the payment or distribution.

The designated beneficiary can be changed from one child to a member of that child's family without triggering any tax consequences. Members of the designated beneficiary's family include the designated beneficiary's:

1) Children and their descendents.

2) Stepchildren and their descendents.

3) Brothers and sisters and their children.

4) Parents and grandparents.

5) Stepparents.

6) Spouses of all the family members listed above.

Transfer incident to divorce. The transfer of a designated beneficiary's interest in an education IRA to his or her spouse or former spouse under a divorce or separation instrument is not a taxable transfer. After the transfer, the interest will be treated as an education IRA in which the spouse or former spouse is the designated beneficiary.

Transfer because of death. The tax treatment of these transfers depends on whether you are the surviving spouse or another designated beneficiary.

Surviving spouse. If your spouse was a designated beneficiary of an education IRA and you receive the education IRA as a result of the death of your spouse, you can treat the education IRA as your own.

Someone other than surviving spouse. If you are someone other than the surviving spouse and you receive an education IRA as the result of the death of the IRA holder, the distribution to you is taxable at its fair market value. You cannot treat the IRA as your own.