The ABCs of Education IRAs

A little-noticed provision in the new federal tax law will make it possible for parents to use tax-favored savings accounts to pay their children’s tuition for private elementary and high schools--or even to pay for tutoring or Internet access.

“It is not exactly a school voucher, but it is the first time the federal government has subsidized private and religious school tuition,” said Joel Packer, a lobbyist for the National Education Assn. in Washington, which opposed the provision.

At the heart of the provision are individual retirement accounts known as education IRAs, tax-favored savings accounts created in 1997 to help parents save for college costs.

Contributions to education IRAs, which are limited to $500 annually for each beneficiary, are not tax deductible. However, money grows in the account on a tax-deferred basis. As long as the money is used for qualified education expenses, all the investment gains can be withdrawn tax-free.

However, when Congress passed tax cut legislation this year, education IRAs were changed in two significant ways.

* Individuals will be able to contribute as much as $2,000 per beneficiary each year. (In this case, the beneficiary is the child for whom the account is opened. A person with five children could contribute $10,000 to education IRAs annually--$2,000 for each child’s account.)

* Tax-free distributions will be allowed for an array of primary and secondary education expenses.

The changes take effect next year.

“Congress really increased the attractiveness of education IRAs,” said Brenda Schaffer, senior tax research coordinator at H&R; Block in Kansas City, Mo. “Not only will you be able to put more money into these accounts, the nontaxable distributions have been expanded considerably.”

In addition to paying college costs, money in these accounts can be used to pay qualified elementary and secondary education expenses without being subject to federal income tax. Allowable expenses include tuition, fees, academic tutoring and specialized services for a special-needs child, as well as books, supplies and school uniforms.

Those who don’t need the money for private school or tutoring can use it to buy a computer, pay for Internet access “and related services” as long as the technology, equipment or services are to be used by the child and the child’s family during any of the years the child is in school.

The education IRA can’t be tapped to pay for game, sports or hobby software, unless those programs are “educational in nature,” according to an analysis of the law by Research Institute of America, a New York-based tax software and publishing concern.

What’s the catch?

If the money is used for anything but qualified education expenses, withdrawals will be subject to both income taxes and penalties. And because there’s no up-front tax deduction, there’s no benefit to putting money into an education IRA and quickly pulling it out.

Even so, in many cases you’re better off spending the IRA money before the child enters college. Why? Education IRAs are saved in the child’s name. That can vastly diminish the student’s ability to qualify for financial aid.

If the student has no other college savings, or if the student wouldn’t qualify for financial aid, this isn’t an issue. But for a middle-income family, there are better ways to save for college, such as state-sponsored 529 education savings plans, which provide a bit more flexibility and have less impact on financial aid.

Anyone can contribute to the education IRA account--parents, grandparents, aunts, uncles, cousins--as long as the total contributions do not exceed $2,000 per year for each child and the person contributing earns no more than $95,000 if single or $190,000 if married. The accounts can be a cost-effective way to finance expensive private high schools.

Here’s how it would work in the case of a hypothetical infant, whom we’ll call Gladys. When Gladys is born, her extended family decides to chip in and open an education IRA with the maximum $2,000 deposit. Gladys’ parents and grandparents continue contributing the maximum amount for the next four years. They then leave the money invested, earning an average of 8% annually, until Gladys is 13 and enrolls in a college-preparatory school.

At that point, she has $23,175--the $10,000 that was contributed by her parents and grandparents, plus $13,175 in investment earnings. If she uses the money to pay for private high school, the entire amount withdrawn is tax-free.

Assuming her parents are in the 30% bracket and otherwise would be paying for her education with taxable dollars, that saves about $4,000 in federal income tax.

What happens if she doesn’t use the money for high school or college?

She has several options: She can transfer the money to another family member who will pay for school or school supplies, or she can leave the money in the account until she’s 30. At that point, the money must be distributed or transferred to another beneficiary, Schaffer said.

If Gladys takes the cash, she’ll pay tax on the profit at her ordinary income-tax rate. She’ll also face a 10% tax penalty.

However, Gladys may have children of her own to whom she could transfer the account. This gives the money even more time to grow.

Let’s say Gladys has a daughter, Hilda, when she is 25. She could transfer the money to Hilda and use it to pay for Hilda’s private school. By then, the IRA would be worth a tidy $60,333. (That assumes an 8% average annual return.)

If Hilda didn’t need the money until college, her mother’s $10,000 in savings could be worth $170,000--just about enough to send Hilda to Harvard.

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Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For past Personal Finance columns visit The Times’ Web site at https://www.latimes.com/perfin.