Education IRA Limits May Increase

By Clifton Linton
Senior Writer, mPower

In This Story Background The Proposal Political Prospects Short-changed Savings? 529 Changes

The Bush Administration has proposed raising education IRA annual contribution limits to $5,000 from the paltry $500 a year currently allowed, and making withdrawals from state-run tuition savings plans exempt from federal taxes.

The proposals, aimed at offering families a bigger tax break when saving for their children's education, generally have support from both parties in Congress. However, some of the fine print is likely to run into opposition from Democrats.

minute: read this article at a glance.

Technical Terms Compound interest Tax deferral

While specific savings program legislation has yet to reach Capitol Hill, Bush sketched out a rough plan in his "No Child Left Behind" education bill introduced in late January 2001.

Background

Education IRAs — somewhat misnamed since they aren't earmarked for retirement — have been around since 1998. Up to $500 a year can be deposited into a child's education IRA by friends or family; the account holder is typically a parent or guardian.

The money is invested as the account holder chooses. Contributions are made with after-tax dollars, but the money grows tax-deferred. Withdrawals are tax-free provided the money is used for education expenses such as tuition, books and housing.

Education IRAs have one big drawback: Currently, even the most diligent savers won't be able to save enough in one to pay for a full four-year degree at most state universities. According to the College Board, tuition at a four-year private college costs $16,322 a year on average and in-state tuition at a public university costs $3,510 a year on average.

Other college savings programs are available but they don't offer tax-exempt withdrawals.

The Proposal

In his "No Child Left Behind" bill, Bush proposed raising the contribution limits for education IRAs to $5,000 and re-naming the accounts "education savings accounts."

He also proposed letting families use the money saved in these accounts to pay for elementary and high school expenses at public, private or religious schools, or for home schooling needs that meet state requirements.

It's the latter proposal that raised Democratic objections, said Dan Maffei, spokesman for Rep. Charles Rangel, D-N.Y., ranking Democrat on the House Ways and Means Committee.

Political Prospects

Bush's proposal is merely "a tax break for the well-to-do and higher, disguised as an education savings account," Maffei said.

Democrats view the provision allowing education IRA money to be spent on private and religious schools as similar to providing vouchers for private school, an issue they strongly oppose.

If the elementary and high school expense provisions were dropped, education savings accounts would be more palatable to the Democrats, Maffei said.

Additionally, the College Plan Savings Network, the trade association that represents state-run tuition programs, objects to raising education IRA limits because this could reduce participation in state-run tuition programs, said Chris Hunter, program manager with the College Savings Plan Network.

Short-changed Savings?

There is a potential financial drawback of Bush's proposal. If families tap education savings accounts for elementary and high school, they likely will miss out on one of the most significant benefits larger contribution limits provide — greater opportunities for interest compounding, said Diane Oakley, vice president with TIAA-CREF.

"You end up in a circumstance where you are not getting the benefit of (interest) compounding over time. That could amount to significant dollars," Oakley said.

Here's an example:

If the Bush proposal became law and a family contributed $5,000 a year to an account over 17 years, the account would have an ending balance of $168,751, assuming an 8 percent interest rate.

But, let's assume the family decides to save for only six years, sending the child to private school when he or she begins first grade. At that point, the account balance would only be $36,680.

Private school can easily run more than $5,000 a year, so that $36,680 could be depleted within seven years if the family only used money from the account to pay for schooling.

However, if the family paid for private school out of pocket and let that $36,680 grow in the account for another 11 years without making any new contributions, the account balance would reach $85,525 through compounding alone.

529 Changes

In addition to changes to education IRAs, Bush wants to exempt withdrawals from state-run 529 tuition savings plans from federal taxes. That idea has support among state savings plan administrators, Hunter says.

Currently, some states exempt 529-plan withdrawals from state income tax, while others allow contributions to be deducted from income for state income tax purposes.

Here's how these plans work. Contributions are made after-tax and the money is allowed to grow tax-free. Contribution limits are set by state governments and, in general, they are much higher than for education IRAs. One common limit is $127,000 per beneficiary over the life of the account. The contribution may be made all at once or spread over time.

Earnings on the account are taxed on withdrawal at the child's tax rate. This can be an advantage if the child has low or no income.

Related Reading Expand College Savings with Education IRAs Your 401(k) Is Not a College Savings Plan — Here's What Is

Investment choices are limited in a 529 plan compared to an education IRA. Typically, you can only invest in the choices offered by the plan.

Bush has also proposed allowing private colleges to set up their own tax-deferred tuition savings programs comparable to 529 plans. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Education IRA Limits May Increase

By Clifton Linton
Senior Writer, mPower

In This Story Background The Proposal Political Prospects Short-changed Savings? 529 Changes

The Bush Administration has proposed raising education IRA annual contribution limits to $5,000 from the paltry $500 a year currently allowed, and making withdrawals from state-run tuition savings plans exempt from federal taxes.

The proposals, aimed at offering families a bigger tax break when saving for their children's education, generally have support from both parties in Congress. However, some of the fine print is likely to run into opposition from Democrats.

minute: read this article at a glance.

Technical Terms Compound interest Tax deferral

While specific savings program legislation has yet to reach Capitol Hill, Bush sketched out a rough plan in his "No Child Left Behind" education bill introduced in late January 2001.

Background

Education IRAs — somewhat misnamed since they aren't earmarked for retirement — have been around since 1998. Up to $500 a year can be deposited into a child's education IRA by friends or family; the account holder is typically a parent or guardian.

The money is invested as the account holder chooses. Contributions are made with after-tax dollars, but the money grows tax-deferred. Withdrawals are tax-free provided the money is used for education expenses such as tuition, books and housing.

Education IRAs have one big drawback: Currently, even the most diligent savers won't be able to save enough in one to pay for a full four-year degree at most state universities. According to the College Board, tuition at a four-year private college costs $16,322 a year on average and in-state tuition at a public university costs $3,510 a year on average.

Other college savings programs are available but they don't offer tax-exempt withdrawals.

The Proposal

In his "No Child Left Behind" bill, Bush proposed raising the contribution limits for education IRAs to $5,000 and re-naming the accounts "education savings accounts."

He also proposed letting families use the money saved in these accounts to pay for elementary and high school expenses at public, private or religious schools, or for home schooling needs that meet state requirements.

It's the latter proposal that raised Democratic objections, said Dan Maffei, spokesman for Rep. Charles Rangel, D-N.Y., ranking Democrat on the House Ways and Means Committee.

Political Prospects

Bush's proposal is merely "a tax break for the well-to-do and higher, disguised as an education savings account," Maffei said.

Democrats view the provision allowing education IRA money to be spent on private and religious schools as similar to providing vouchers for private school, an issue they strongly oppose.

If the elementary and high school expense provisions were dropped, education savings accounts would be more palatable to the Democrats, Maffei said.

Additionally, the College Plan Savings Network, the trade association that represents state-run tuition programs, objects to raising education IRA limits because this could reduce participation in state-run tuition programs, said Chris Hunter, program manager with the College Savings Plan Network.

Short-changed Savings?

There is a potential financial drawback of Bush's proposal. If families tap education savings accounts for elementary and high school, they likely will miss out on one of the most significant benefits larger contribution limits provide — greater opportunities for interest compounding, said Diane Oakley, vice president with TIAA-CREF.

"You end up in a circumstance where you are not getting the benefit of (interest) compounding over time. That could amount to significant dollars," Oakley said.

Here's an example:

If the Bush proposal became law and a family contributed $5,000 a year to an account over 17 years, the account would have an ending balance of $168,751, assuming an 8 percent interest rate.

But, let's assume the family decides to save for only six years, sending the child to private school when he or she begins first grade. At that point, the account balance would only be $36,680.

Private school can easily run more than $5,000 a year, so that $36,680 could be depleted within seven years if the family only used money from the account to pay for schooling.

However, if the family paid for private school out of pocket and let that $36,680 grow in the account for another 11 years without making any new contributions, the account balance would reach $85,525 through compounding alone.

529 Changes

In addition to changes to education IRAs, Bush wants to exempt withdrawals from state-run 529 tuition savings plans from federal taxes. That idea has support among state savings plan administrators, Hunter says.

Currently, some states exempt 529-plan withdrawals from state income tax, while others allow contributions to be deducted from income for state income tax purposes.

Here's how these plans work. Contributions are made after-tax and the money is allowed to grow tax-free. Contribution limits are set by state governments and, in general, they are much higher than for education IRAs. One common limit is $127,000 per beneficiary over the life of the account. The contribution may be made all at once or spread over time.

Earnings on the account are taxed on withdrawal at the child's tax rate. This can be an advantage if the child has low or no income.

Related Reading Expand College Savings with Education IRAs Your 401(k) Is Not a College Savings Plan — Here's What Is

Investment choices are limited in a 529 plan compared to an education IRA. Typically, you can only invest in the choices offered by the plan.

Bush has also proposed allowing private colleges to set up their own tax-deferred tuition savings programs comparable to 529 plans. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.