Get Smart: Are education IRAs a wise choice?

What you hear about options for funding your child's college education can be so confusing. You may have heard of education IRAs, for example. These IRAs (individual retirement accounts) came into being with the Taxpayer Relief Act of 1997. They are custodial accounts created just for the purpose of paying college expenses. Education IRAs allow parents to make tax-free contributions of up to $500 per year.

You can contribute to an education IRA unless you're a joint filer with an adjusted gross income between $150,000 and $160,000 or a single filer with an adjusted gross income between $95,000 and $110,000. The money that is saved can be used for tuition, fees, books, supplies, equipment and some room and board expenses for full-time and half-time students. You have to make contributions before the child turns 18 years old.

If the money isn't used for college by the time the child turns 30, you can either incur a 10% penalty or pay taxes to get your money, or roll the account over into another IRA with no penalty. So, if it doesn't work for education it can supplement your retirement IRA. Or if one child doesn't want to go to college, you can use the money for another child.

What are the drawbacks?

If you're enrolled in a state tuition or education savings program, you can't withdraw from and use an education IRA at the same time. In other words, you can't count on using the education IRA as part of the funding mix.

You also can't use a new Hope tax credit or a Lifetime Learning credit and withdraw from an education IRA at the same time. The Hope credit helps make the first two years of college or vocational school affordable. Students get a 100% tax credit for the first $1,000 of tuition and fees and a 50% credit on the second $1,000. The credit is available for tuition and required fees less grants, scholarships and other tax-free assistance. The Hope credit is phased out for joint filers who have between $80,000 and $100,000 of adjusted gross income and for single filers who have between $40,000 and $50,000 of adjusted gross income.

If you open the account right after your baby is born, the account would be worth about $15,000 to $16,000 in 18 years, a drop in the bucket compared to the predicted $100,000 cost of a four-year college education in a public institution.

Because the account is in the child's name, you may be in a worse position to get financial aid when the time comes. Most financial aid formulas require students to contribute 35% of their savings, while parents are required to supply only 5.6% of theirs.

If you want to plan for a full, four-year college education and want your child to be eligible for financial aid, an education IRA may not be the best choice.

Date last reviewed: October 2002.

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