By now, you might have heard that beginning in 2002, you can contribute up to $2,000 annually to an Education IRA, compared to the current $500 yearly maximum. What many people aren't aware of is that recently passed tax-reform legislation greatly expands what you can spend this money on.
Previously your Education IRA could only be used to pay for college expenses. Beginning in 2002, you can tap these funds tax free to pay for a gamut of qualified school-related expenses not only for college but also for private and public primary and secondary educational institutions. Qualified expenses may include: computer equipment and software (no games) used by the student and other household members for educational purposes; Internet service used by the student and other household members for educational purposes (e.g. research for a term paper); tutoring; school uniforms; books and school supplies; transportation; room and board and tuition; and extended-day school programs.
By paying these and other education-related expenses with your Education IRA, you pay no taxes on your withdrawals, which gives you more buying power.
For example, if you contributed the $500 maximum to an Education IRA this year for your newborn child and then contributed the $2,000 maximum next year and every year until your child turns enters kindergarten, you could potentially accumulate $15,465 at an 8 percent annual compounded rate of return.
That money can be withdrawn tax free, which is a much better deal than if you had saved that money in an interest-bearing savings account and then had to pay taxes on the interest you earned.
Consider using a combination of an Education IRA and a 529 college savings plan if you want to save for your children's college and primary and secondary school education. The 529 plans can only be used for college expenses, but the Education IRA could be available to pay for school-related expenses until college. However, unlike other savings plans such as Education IRAs, anyone at any income level can contribute to a 529 plan.
Beginning next year, 529 plan withdrawals also will be federally tax-free. In addition, U.S. residents can participate in any state's 529 plan and set up accounts for their children, grandchildren, friends or even themselves. But keep in mind that each state's plan may invest your contributions differently and levy its own costs and fees. Be sure to shop around for the 529 plan that best fits your needs.
Education IRAs and 529 plans are a one-two punch that is hard to beat. With college expenses increasing faster than inflation, parents need all the help they can get. Your financial consultant can help you determine which savings plan, or combination, is the best strategy for you.
Steve Zeller is a financial consultant with A.G. Edwards & Sons Inc., member SIPC, 379 Lytton Ave., Palo Alto 94301. For information, call 326-5010.