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.