Basics of Education IRAS & College Investment

As college tuition continues to rise, many people are faced with the question of how they will be able to afford to send their children to school. One way of investing in your child’s future is with an Education Savings Account; formally know as an Education IRA. New laws that took effect in 2002 have made Education Savings Accounts more tax beneficial; therefore, making them even more profitable.

You can contribute $2,000 a year to be used toward your child’s education. If your adjusted gross income is less than $95,000 and you’re single or less than $190,000 and you’re married, you can make the full $2,000 contribution per child. For example, if you have an 8% rate of return over 18 years on an annual contribution of $2,000, you would have an account balance of $80,000.

The contributions to this account are flexible. Qualified individuals, such as grandparents, other relatives, and friends, can contribute to an Education Savings Account on behalf of a student. The student can even contribute as long as his/her income doesn't exceed the allotted amount. There is also no maximum contribution limit per donor, as long as it is made on the behalf of a child who is 18 years or under.

Withdrawals from the Education Savings Account are free from federal income tax as long as they are used for specified costs associated with education. These qualified costs are tuition fees, academic tutoring, special needs services, books, supplies and equipment used for elementary, secondary and post secondary education. The accepted costs also include room and board, uniforms, and transportation, as long as the beneficiary or the beneficiary's family uses it during any year the beneficiary is in school. If withdrawals do not meet the tax-free requirements, earnings are taxed as income and maybe subject to a 10% withdrawal penalty.

You will be subject to federal income tax and penalties if the students do not make withdrawals by their 30th birthday. Of course, there are special exceptions, such as a special needs student. These consequences can be avoided a couple of ways. Before you reach your 30th birthday, you can roll over or transfer your account balance to another member of your family under 30 or a special needs student. You could also change the beneficiary of the account. This must be done no later than the day before you turn 30.

There are advantages and disadvantages to an Education Savings Account. Some of the advantages have been discussed in previous paragraphs (tax free growth and flexible contributions). Another advantage is that the parent or guardian maintains control of the account. This helps to ensure the money is used for education purposes. Of course, once the student turns 18 they take over control of the account.

A disadvantage to an Education Savings Account is that a $2,000 a year contribution may not be enough to completely pay for your child's education. The Education Savings Account should be part of an overall financial plan. Another disadvantage is this savings account could affect the student's ability to receive financial aid. The financial aid is based on the student’s income more so than the parents. Also, you must remember that prices of shares fluctuate, and the rate of return is not guaranteed.

There is nothing more important for your child's future than education. Since the government changed the laws in 2002, the Education Savings Account has become a profitable way to save money for education costs. This may not be enough to cover the total cost of sending your child to school, but it is a great place to start.