Thank the Investor Relief Act of 1997 for this handy dandy little device and the tax cut of 2001 for improving it. An Education IRA is a special investment retirement account that, starting in 2002, let's you invest up to $2,000 a year for each child under 18 for their education-related expenses. Why is this nice? The money grows tax-deferred and can be withdrawn tax-free. That means: no taxes. Nada.
Not impressed? If you open up an Education IRA for your newborn and deposit just $500 a year at 10 percent, in 18 years you'll have accumulated $18,300, give or take. If you had to pay taxes on it (at the 28 percent bracket) then you'd only have $15,100. That's a nice little tax benefit, and it was all rather painlessly accumulated. If you deposit the maximum of $2,000, you'd have $73,213 tax free. ($60,433 if you had to pay taxes.) Nice.
Until 2001, any individual can contribute up to $500 to a child's Education IRA if the individual's modified adjusted gross income for the taxable year is no more than $95,000 or $150,000 for married taxpayers filing jointly. Now, thanks to the tax cut of 2001, you'll be able to quadruple your annual contribution per child. Nice. Further, you'll now be able to put the money toward the cost of kindergarten through high school, not just the cost of higher education. And, the AGI levels have increased slightly, so check with your bank or brokerage to see if you qualify.
Here's another change–until this year, you were not allowed to contribute to both an Education IRA and a 529 state-sponsored savings plan in the same year. Now, you can. If you are looking to pay for elementary and secondary school expenses, then the Education IRA is tough to beat. (If your child uses the money for anything other than education expenses, expect a tax bill and a 10% penalty.)
Contributions to an Education IRA are not tax-deductible. One great thing, however, the IRA can be rolled over to another family member who is a student. So, let's say that 17-year-old Jane has earned a serious scholarship and won't need her $12,000 Education IRA money. She can transfer that account to her beloved eight-year old brother, who now has a great jump-start on his college savings plan.
Here's a tip: Get a grandparent to open an Education IRA for your child. Grandparents often have lower incomes and tax brackets, and usually do not exceed the AGI ceilings. Just remember, $2,000 is the maximum that can be contributed during a calendar year.