While the simplicity of college-savings (or 529) plans appeals to many investors, the limits on investment choices rankle others. If you feel straitjacketed, consider the new and improved education IRA.
Although tax-free from their inception in 1997, education IRAs have been hobbled by a puny $500 ceiling on annual contributions. Beginning in 2002, however, you'll be able to contribute up to $2,000 a year, a more reasonable cap that should bring these accounts to life.
Like retirement-flavored IRAs, education IRAs are offered by banks, mutual funds and brokerage companies — and you have full discretion to buy and sell what you want. Like Roth IRAs, you get no tax deduction when money goes into the account.
If you contribute the maximum for a newborn from his first year in 2002 to his 18th and you earn 10 percent a year, the account will grow to just about $100,000. If you want to save more, you can now supplement your savings with contributions to a 529 plan. Congress has eliminated the ban on making contributions to both kinds of plans in the same year.
The new tax law remedies another serious shortcoming. Through this year, you cannot take a Hope or Lifetime Learning tax credit in the same year you make a withdrawal from an education IRA. Beginning next year, that restriction disappears.
Another plus is that you can use tax-free withdrawals from education IRAs to pay for private elementary and high school expenses. So if pre-college tuition bills are in your future, you could save for them in an education IRA and use a 529 plan for college. As with a 529 plan, you control the account until it's used for a qualified expense; you can transfer the money to another family member if the original beneficiary doesn't go to college; and you pay a 10-percent-of-earnings penalty if the money is used for a nonqualified expense. One distinction: No education-IRA beneficiary may be older than age 30.
There are income limits for contributing to education IRAs. You can contribute fully only if your adjusted gross income is less than $95,000 on a single return or $190,000 on a joint return. But this has little real-world impact because parents who make more than the limit could, for example, give $2,000 a year to a grandparent, who could then contribute to an education IRA for the child.