Education IRA was created by the 1997 Taxpayer Relief Act . Actually calling this investment an "IRA" is a misnomer; the Education IRA has nothing to do with saving for retirement. It was created to assist parents in setting aside funds for a child's post-secondary education.
The Education IRA allows individuals to set aside up to $500 per child per year. The money grows tax-deferred and can be withdrawn without paying any taxes if the funds are used for post-secondary education expenses. Contributions can be made to an Education IRA by anyone such as parents, grandparents, friends, and relatives. Full contribution is allowed only if the contributor's adjusted gross income is less than $95,000 (single) or $150,000 (married filing jointly).
Don't be dismayed if your income exceeds these levels; you still may be able to provide the funding for an Education IRA. Let's say you are a wealthy uncle who wants to set aside $500 per year for five nieces and nephews. Even though your income requirements may not allow you to open the account, you still may be able to provide the funding by giving the parents of the children a gift in the dollar amount required to fund the accounts. Remember: You can give anyone a tax-free gift of up to $10,000 per year. As long as the parents' income don't exceeds the upper limits, the parents can take your gift and use the money to fund the Education IRAs. What if the parents' income exceeds the upper limits to contribute to an Education IRA? The parents could give "gift" money to a friend or relative whose income is within allowable limits to make an Education IRA contribution. The friend or relative could then be the contributor. Regardless of who contributes the money, the account is controlled by the parents until the funds are distributed or the child reaches the age of 30, which is also when the funds must be distributed. Earnings are taxed and penalized if not used for education expenses by age 30.
One of the positive aspects of the Education IRA is that you can shift the funds from one child to a sibling if need be. For example, let's say you open Education IRAs for your two children. After saving for many years, one of the children decides against enrolling in college. Rules governing Education IRAs allow you to take that money and combine it with the funds from the Education IRA for your other child.
The downside of an Education IRA is that the money contributed is not tax-deductible. Also, because the annual limits are only $500 per child, the plans don't provide an opportunity to set aside big dollars, especially for a youngster in his or her teens. Still, I think anything that helps make it easier for investors to save money, whether for college education or retirement, is a worthwhile investment. How should these monies be invested? Mutual funds are likely to be the investment of choice for an Education IRA. How aggressive you should be with these funds depends primarily on the amount of time until the funds are likely to be withdrawn.
