Education IRA is best if you start it early


SO FAR, the new education IRA has been pretty much a bust. Middle-income parents may skip them, in favor of the new education tax credits (see below). Higher-income parents may consider this IRA too small to bother with.

The Strong Funds in Milwaukee, Wis., however, say 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 month 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'll 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'll veto the proposal.

So you're probably still looking at a $500 education IRA. Should you use it?

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 about $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 about $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 2003).

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. If you start when your child is 8, however, the tax credits will probably be worth more.

The future is guesswork, but you get the idea: education IRAs for early and disciplined planners or higher-income people; tax credits for middle-income people who didn't save early.

You're fully eligible for the new tax credits if your adjusted gross income is less than $40,000 on a single return or $80,000 on a joint return. Above those limits, the credits phase out. These amounts will rise with inflation, starting in 2002.

Back to education IRAs. Here are some other possible glitches: You can't fund an IRA in a year you contribute to a state prepaid tuition plan, and some states are offering plans that look pretty attractive.

The more the child has in savings, the less financial aid he or she will qualify for. (But this is no reason not to save. Nonsavers get stuck with more student loans.)

If the child doesn't go past high school, the IRA can be transferred tax-free to another child. But any money not used by age 30 must be withdrawn and taxed to the child, with a 10 percent penalty.

Education IRAs aren't publicized much. But you can find them at banks, stockbrokerage firms and mutual fund groups.

Pub Date: 5/11/98

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