Paying for Education Using Tax Advantages

By Michael L. Brunner

It's never too early to begin preparing to finance a college education.
Thanks to recent legislation, there are more options from which to choose. Among them are IRAs (education, traditional and Roth - under certain circumstances) and state-sponsored programs. These tax-favored savings vehicles deserve a close look.

Section 529 Savings Plans These state-sponsored plans allow more investment in a tax-advantaged program. Any U.S. resident can invest in such plans and withdrawals can be used at any eligible postsecondary school in the country.

Qualified withdrawals from any state-sponsored college savings plan or qualified tuition program will be free from federal income taxes until at least Dec. 31, 2010. Congress must extend the law after that date.

Distributions will be taxed at the beneficiary's tax rate if the legislation is not extended. Also, many states extend favorable tax deductions and tax-free withdrawals to state residents who invest in a home-state plan.

State-sponsored savings plans offer grandparents and other older relatives to contribute up to $55,000 ($110,000 for married couples) per beneficiary in one year without incurring gift taxes. These dollars are considered to be a completed gift and out of the donor's estate unless the account owner dies within five years of the gift. In that case, a prorated portion of the original contribution amount will be included in the donor's taxable estate.

Education savings account contributions or distributions are permitted even if contributions or withdrawals from a Section 529 college savings plan are made in the same year. HOPE Scholarships and Lifetime Learning credits may also be claimed in the same year as an ESA or Section 529 college savings plan distribution as long as different expenses are claimed.

The Education Savings Account In 2002 the maximum annual contribution to an ESA (formerly, the education IRA) increased to $2000 per child for married taxpayers who file a joint tax return and have adjusted gross income of up to $190,000. The ability to contribute phases out for salaries between $190,000 and $220,000. This is a $40,000 increase over previous limits.

In addition to college or graduate school, these funds may be used to cover elementary through secondary school expenses. All earnings will be exempt from federal, state and local tax as long as the account is used to pay for qualified expenses. Certain out-of-pocket expenses can even come out of an ESA for children attending a public grade school.

The new tax law allows the use of tax-free distributions to purchase computer equipment, uniforms and transportation, extended-day programs, academic tutoring, books and supplies, as well as tuition and room and board at public, private or religious schools.

A Word on Traditional and Roth IRAs Early withdrawals from a traditional IRA used to pay higher-education expenses can be done without paying the 10 percent penalty, but any regular income taxes due on the amount withdrawn will still be applicable. Hence, the education savings account is a better choice.
The benefit of a Roth IRA is that it allows (if it has been established and funded for five years or more) penalty-free withdrawal of earnings for educational purposes before the age of 59 and a half. Any earnings taken out will be subject to regular income tax.