Education IRAs For A Lifetime

So far, the new Education IRAs has been pretty much a bust. Middle-income parents may skip them in favor of the new education tax credits. Higher-income parents may consider this IRA too small to bother with. The Strong Funds in Milwaukee, Wis., however, say that interest is picking up.

With Education IRAs, you can invest up to $500 a year for every child under 18. There's no immediate tax deduction. But the earnings on your money are entirely tax free if spent on higher education. The Senate voted last week to raise the annual contribution to $2,000. Last year, the House proposed a limit of $2,500. But these two bills also extend the Education IRA to parents who will send children to private or parochial elementary and secondary schools.

This embroils the IRA in the fight over whether to use the tax code to help children leave the public school system. President Clinton says he will veto the proposal. So you're probably still looking at a $500 Education IRA. Should you use it?

I'd say definitely yes, if you're in the right financial situation. Even small tax breaks are better than a kick in the shin. Education IRAs are available only for children under 18. You can put in $500 a year on top of the $2,000 you might invest in a traditional IRA or a Roth IRA.

Grandparents, other relatives, godparents or friends could also establish the IRA. But no more than $500 total can be invested for each child, each year. If grandma puts in $300, dad can add only $200 more. There's a 6 percent penalty on excess contributions. Typical annual fee: $10 or $15, although the Strong Funds and some others charge zero. To make a full Education IRA contribution, your adjusted gross income has to be less than $95,000 on a single return or $150,000 on a joint return. Above these limits, the contribution phases out.

If you put in the maximum from the time the child is born, and your money earns 10 percent a year, you'll have around $22,500 in 18 years. In 2016, that might cover two-thirds of a year at a public college in your state, which isn't too bad. Subtracting your contributions, you'd have accumulated $13,500 tax free.

If your child is 8 when you start to save, however, you'd accumulate only around $3,800 tax free, not counting contributions. At this point, middle-income people should consider other options. Two new education tax credits are available. But you cannot claim them in any year that you withdraw funds from an Education IRA to help pay for school. You have to choose between the IRA and the credits. Which one is better?

The credits are worth up to $1,500 a year for the child's first two years of school. For each year thereafter, you can claim up to $1,000 ($2,000 starting in 2006). That comes to a total of $5,000 (or $7,000), for four years of school. The IRA will probably be worth more than that amount if you start it when the child is born.

Education IRA