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Paying for College Education: Gifting and Educational IRAs

This article provides an overview of two methods for college saving.

With the rising cost of higher education, many parents are concerned about having sufficient funds to send their children to college. This article provides an overview of two methods for college saving.

Gifting and Custodial Accounts

Regular gifting to a child can cover a major part of college expenses. A useful vehicle for gifting is a custodial account – an account established in your name with a child designated as beneficiary. By designating the child as beneficiary and using his/her Social Security number for the account, it may be possible to reduce the federal taxes on the income.

For example, if a child is under age 14, the first $700 (1999 amount) in income from custodial accounts is exempt from taxes. The next $700 is taxed at the child’s rate, usually 15 percent. Income earned in excess of $1,400 is taxed at the parent’s highest marginal rate. If the child is 14 or older, all net investment income earned is taxed at the child’s rate, usually 15 percent. If however, you hold the child’s investment in your name alone, all income and capital gain distributions are taxed at your rate. Depending on the size of the college fund, you could incur a substantial tax liability.

A custodial account has one major drawback, however. You no longer will have control over the funds when your child reaches majority age. In addition, investing in your child’s name may adversely affect your child’s eligibility for financial aid. Finally, you may want to consider the estate tax consequences of having a custodial account.

Education IRAs

EIRAs offer a sound alternative to custodial accounts since any portion of an EIRA’s earnings that are not spent for educational purposes are subject both to tax and penalty. This provides an incentive for the child to use the funds as intended.

EIRAs offer a real tax advantage. Although contributions to EIRAs are not tax deductible, the earnings in an EIRA accumulate tax-free. Furthermore, distributions from an EIRA are tax-free if used for post-secondary educational expenses such as room, board and tuition. This includes not only the amount contributed but also any earnings. To avoid tax, the funds in an EIRA must either be distributed to the child designated as beneficiary or rolled over to another family member before the beneficiary reaches age 30. Any balance remaining in an account before the beneficiary reaches age 30 may be rolled over to an EIRA for another eligible family member. This rollover allows earnings to continue to grow tax-free. Furthermore, if the beneficiary receives a scholarship (and therefore does not need funds from the EIRA), a distribution of not more than the amount of the scholarship may be taken without penalty.

There is no limit to the number of EIRAs that can be established designating the same child as beneficiary. However, total contributions for the child during any tax year cannot be more than $500 and contributions must be made by December 31. If $500 is contributed for 18 years and the funds invested at seven percent, the EIRA will grow to about $17,000. Using the EIRA, the $8,000 in earnings would not be subject to tax.

Eligibility to make the maximum EIRA contribution begins to phase out for taxpayers filing jointly with a Modified Adjusted Gross Income (MAGI) of $150,000 to $160,000 and for single taxpayers with MAGI of $95,000 to $110,000 (1999 amounts). Anyone whose income is below these levels can contribute to an EIRA for any child (not necessarily a relative) as long as the total contributions to an account in the child’s name do not exceed $500 a year. This wide eligibility can be extremely beneficial if, for example, a child’s parents cannot afford the contribution or if the parents’ MAGI exceeds the limit.

EIRAs have two drawbacks. First, you cannot claim either the Hope Scholarship Credit or the Lifetime Learning Credit in the same year that you use a distribution from an EIRA to pay qualified education expenses. Second, investing in an EIRA for your child may adversely affect your child’s eligibility for financial aid.

For additional EIRA information, see IRS Publication 590 online at www.irs.ustreas.gov. You can apply for financial aid on line at www.fafsa.ed.gov. The information contained in this article is for general use only. It should be relied upon only when coordinated with professional tax and financial advice.

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