Education IRAs Are Now Viable Savings Vehicles

Until now, most commentators were critical of Education IRAs, mainly because of the skimpy $500 annual limit on contributions. In many cases, account management fees ate up a good chunk of the investment returns because so little money could be put into play with these accounts. 

Thankfully, this is no longer the case. Starting in 2002, you can contribute up to $2,000 annually to an Education IRA. If you have several children (or grandchildren), you can contribute that much to individual accounts set up to benefit each. So, if you have three kids, you can sock away up to $6,000 every year. Account earnings are allowed to build up tax-free and can then be withdrawn tax-free to pay for the account beneficiary's college expenses. Of course, the contributions themselves are nondeductible (just like contributions to Roth IRAs). So far, so good. 

Even better, you'll be able to take tax-free Education IRA withdrawals to pay for elementary and secondary school (K-12) expenses starting in 2002. Eligible expenses will include tuition and fees to attend private and religious K-12 schools as well as costs to attend public K-12 schools. What kind of expenses can you cover? The rules are pretty liberal. Eligible items include books and supplies; computers, peripheral equipment, and software (as long as the program is primarily educational in nature); room and board; school uniforms; transportation; academic tutoring; and even Internet access charges. In the case of computers and related equipment, it's okay if other family members use them as long as the Education IRA beneficiary also uses them during any year he or she is in school. 

Starting in 2002, you will also be allowed to take tax-free withdrawals from an Education IRA in the same year the Hope Scholarship or Lifetime Learning tax credit is claimed for the account beneficiary's college expenses. However, the same expenses cannot be used to claim both breaks. 

Starting with contributions related to the 2002 tax year, you'll have until April 15th of the following year to make your annual Education IRA contributions. This is the same deadline as for traditional and Roth IRA contributions. (Prior to 2002, Education IRA contributions must have been made by the end of the year to which they related.) 

Finally, the adjusted gross income (AGI) phase-out range that limits Education IRA contributions for high-income taxpayers will be increased to between $190,000 and $220,000 for joint filers in 2002. (In 2001 the range was between $150,000 and $160,000.) However, the phase-out range for single, head of household, and married filing separate status will remain at AGI of $95,000 to $110,000. 

After all these favorable changes, Education IRAs are now prime-time education savings vehicles. Of course, the tax advantages multiply dramatically if you start contributing while your children are still quite young. In particular, you must start very early to gain any meaningful tax savings if you intend to use Education IRA withdrawals to cover K-12 expenses. 

Qualified Tuition Plans Are Now Terrific

Until now, so-called qualified state tuition programs (also called QSTPs and Section 529 plans) were pretty good deals. These state-sponsored arrangements delivered tax-deferral advantages until payouts were taken to cover eligible college costs. And earnings included in those payouts were taxed at the student's low rate, rather than at the presumably much higher rate applicable to the person who funded the account (typically the parent). 

The new law makes these programs a great deal, rather than just a good one. Effective in 2002, they will be redesignated as "qualified tuition programs" (QTPs). More importantly, payouts to cover eligible higher education expenses will become tax-free. Obviously, tax-free is much better than tax-deferred. This change will apply equally to new and existing accounts. So, QTPs have suddenly become a terrific opportunity for parents who can afford to start college savings programs while their children are still fairly young. Simply put, the generous tax advantages mean much less need be taken out of your financial hide to fully provide for your children's future college costs. 

Currently, most state-sponsored college savings account plans allow you to make lump-sum contributions of up to $100,000 or in some instances more. Typically, you are offered several investment alternatives, including selected equity mutual funds. If the account's investments outperform the rate of inflation for college costs, you come out that much ahead of the game. Also, most college savings account plans now welcome out-of-state investors and will cover expenses from any accredited college in the U.S. So, you can shop around to find the program you like best. (However, some plans offer significant state tax advantages for in-state residents.) 

Under the new law, you will also be able to transfer money tax-free from one QTP account into another QTP account set up for the same beneficiary. So, if you decide another program is better than the one you're in, you can effectively make a tax-free rollover into the better program. Similarly, you can transfer money from one family member's QTP account tax-free into another family member's account within the same state-sponsored program or another state's program. Starting in 2002, "family members" will include first cousins of the account beneficiary. 

Finally, beginning in 2002 the new law permits private educational institutions to sponsor tax-free QTPs that offer prepaid tuition credits or certificates. Unlike state-sponsored QTPs, however, these private programs will not be allowed to offer the more flexible and attractive college savings account arrangements. For this reason, the state-sponsored programs will probably continue to be the preferred choice for most people. Also, the new rule allowing tax-free payouts from privately sponsored QTPs doesn't become effective until 2004 (even though the accounts can be opened beginning in 2002). 

This is all great news, but perhaps the nicest thing about QTPs is they are available to all taxpayers, regardless of how high their income. That's not the case for most of the other breaks covered in this letter. 

Observation:

A lot of taxpayers are going to have the option of contributing to either a QTP or an Education IRA (or both, even though with the latter the ability to contribute begins to phase out once adjusted gross income reaches $95,000 for singles or $190,000 on joint returns). So which should you choose? 

As a result of the changes discussed earlier, they both offer the opportunity to accumulate earnings tax-free. However, beyond that, several differences exist. For example, if there's a chance your family might qualify for financial aid, a QTP looks more appealing because it counts as the donor's asset in the financial aid formula while an Education IRA is considered the student's asset. (Student assets count against you more heavily in the formula.) QTPs also have the advantage when it comes to funding because the annual limit on contributing to an Education IRA is still only $2,000 (beginning in 2002), but up to $50,000 can be stuffed gift-tax-free into a QTP in one year if you elect to spread that amount over a five-year period. Of course, Education IRAs have some advantages of their own. Tax-free distributions from such accounts can be used for schooling at the high school or lower level, while this won't work with a QTP. In addition, Education IRAs offer you more control over how contributed funds are invested, and the investment costs themselves can be lower than they would be in a QTP. Thus, like a lot of things in life, which (if either) of these education savings vehicles you select depends on your own unique circumstances. 

New Deduction for College Expenditures

Why can't you just outright deduct college costs? Good question. In fact, you may be able to starting in 2002. A brand-new break will allow you to write off up to $3,000 of college tuition and fees for you, your spouse, or any person who can be claimed as a dependent on your tax return. This new deduction will be "above-the-line," meaning you need not itemize to benefit. However, the deduction will vaporize once your AGI exceeds $65,000 if you are single or $130,000 if you file a joint return. (There's no gradual phaseout here; you will either be 100% eligible or 100% ineligible.) 

In 2004 and 2005, the maximum deduction will increase to $4,000 and be subject to the same AGI limits. However, in those two years, singles with AGI between $65,000 and $80,000 will be entitled to a maximum $2,000 deduction, and so will joint filers with AGI between $130,000 and $160,000. 

That's the good news. Now for all the restrictions. 

First, you are completely ineligible for this write-off if you are married and file separately from your spouse.

No deduction is allowed to any person who can be claimed as a dependent on another person's return. 

You cannot take tax-free Education IRA or tax-free QTP payouts for college expenses and then claim a deduction for those very same expenses.

Similarly, you cannot claim the Hope Scholarship or Lifetime Learning tax credit for college expenses and then claim a deduction for the very same expenses.

Finally, this new break will expire after 2005 unless Congress takes action to extend the deal.

More Liberal Rules for College Loan Interest Deduction

Under current law, you can deduct up to $2,500 of annual interest paid on loans to finance college expenses. However, the deduction is limited to the first 60 months interest is due even if the loan is for a longer term. Starting in 2002, the 60-month rule will be eliminated. In addition, the phase-out rule that reduces or eliminates deductions for higher-income taxpayers will be liberalized. Also starting in 2002, the phase-out range will be between AGI of $50,000 and $65,000 for singles (up from the current range of $40,000 to $55,000) and between AGI of $100,000 and $130,000 for joint filers (up from $60,000 to $75,000). Bottom line: you are now more likely to qualify for this write-off.

Tax-Free Employer Education Reimbursements Made Permanent

The rule allowing tax-free employer reimbursements for up to $5,250 of an employee's annual education expenses was scheduled to expire at the end of 2001. The new law makes this break a permanent fixture in the Tax Code. Starting in 2002, you'll also be able to receive tax-free reimbursements for graduate courses. Until then, reimbursements for graduate courses don't qualify.

Conclusions

That's the full scoop on all the new education tax incentives. Hopefully, you'll be able to take advantage of one or several of these valuable benefits. In particular, you might want to start saving up your money right now if the new and improved Education IRA or the new and improved QTP accounts look attractive.

If you have questions about any of the provisions explained in this letter or any questions at all about the new tax law in general, please don't hesitate to call. We look forward to assisting you in planning to reap tax savings from all the good things the new law offers.