An education savings account is a special account created to pay for a child’s "qualified" education expenses. Parents, grandparents, and others can make nondeductible contributions each year until a child reaches age 18. Funds in the account accumulate tax-free. Withdrawals are tax-free as long as they do not exceed the qualified education expenses paid.

The Tax Relief Act of 2001 made several changes to the rules governing education savings accounts. If in the past you rejected these accounts as a way to save for college, you may want to have another look at them now.
 

The old rules

The rules for education savings accounts were more restrictive prior to 2002. First, only individuals could make contributions to education IRAs and then only if their income didn't exceed certain levels. Second, distributions were tax-free only when used to pay qualified higher education expenses.

Perhaps the biggest drawback to education IRAs prior to 2002 was the limit on the contribution amount - $500. Such a low contribution limit gave this tax break limited appeal. After all, 18 years of $500 contributions invested at 8% would yield only about $20,000. Roth IRAs, regular IRAs, and prepaid tuition programs usually produced better results.

Finally, contributions had to be made by December 31 of the year for which they were being made.


New rules for 2002

Starting in 2002, the rules for education savings accounts changed to allow annual contributions of up to $2,000. Contributions can be made up to the due date (not including extensions) of the tax return for the year of the contribution. 

Also starting in 2002, education IRA funds may be used to pay for elementary and secondary school expenses, not just higher education costs. Qualified education expenses include tuition, fees, books, supplies, equipment, and certain room and board expenses. The student need not attend full-time, but room and board will qualify only if the student attends at least half-time.

Though there are still income limits for individuals who make contributions to education savings accounts, the phase-out income range for married taxpayers filing jointly increased in 2002. Phase-out begins at $190,000 of income and ends at $220,000. The phase-out range for singles begins at $95,000 and ends at $110,000. For the first time, contributions can be made by corporations and other entities, regardless of their income.

Beginning in 2002, a Hope or lifetime learning tax credit can be claimed in the same year that education IRA distributions are taken, as long as different expenses are covered by each.

In analyzing your options for building an education fund, the education savings account is certainly worth checking out. For details, give us a call.

 

For help in understanding and comparing these and other education financing alternatives, please call our office or send your questions to us via e-mail.

Back to Family Tax Planning