Are sec. 529 plans a better choice than education IRAs?

• Author: Moore, Philip E.
• Position: Qualified tuition programs vs. individual retirement accounts, IRC section 529

The rising cost of higher education has put a tremendous burden on parents today and/he outlook is for still higher costs in the future. In addition, parents find themselves confused and frustrated in trying to determine how best to save for college. Should they use Education IRAs, or qualified tuition programs (Sec. 529 plans) to save? Should they just set up their own portfolios, forgetting about tax benefits? Tax advisers can help parents identify the best ways to save for their children's education and relieve much of their confusion.

Education IRAs

The attractiveness of Education IRAs has been considerably enhanced by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). An Education IRA is an account set up by a donor to help pay for a beneficiary's future education expenses. Although contributions to an Education IRA are not deductible by the donor for tax purposes, he does not pay tax currently on any earnings on the account. Under both the new and the old law, distributions used for the beneficiary's qualified educational expenses are tax-free at the time of the distribution and are not included in the beneficiary's gross income.

As a result of the EGTRRA, the importance of Education IRAs as a planning tool is increased. The EGTRRA changes become effective in 2002 and expire in 2010; however, it is likely that Congress will extend the new provisions. Under the new law, the annual contribution limit is increased from $500 to $2,000, applying separately to each beneficiary, rather than per contributor. Therefore, a donor may contribute $2,000 each to multiple beneficiary accounts. The EGTRRA also expands the definition of "qualified education expenses" to include the cost of a beneficiary's elementary and secondary school expenses, rather than just post-secondary (undergraduate and graduate) expenses. However, if a taxpayer knows that the beneficiary will decide to go to college, he should leave the contributed amounts in the Education IRA so earnings can grow tax-free for the longest period of time allowed, which would make much more sense than using them on a short-term basis.

As mentioned, distributions for qualified education expenses may be withdrawn tax-free. Further, a taxpayer can claim the Hope Credit and the Lifetime Learning Credit in the same year there is a distribution from an Education IRA, provided that he does not use the distribution to cover expenses for which he claims the credits. Lastly (and...