Education IRA: Definition & Characteristics

Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

College costs a lot of money, and many parents want to save for their children's college education. One option that offers tax breaks is an education IRA. In this lesson, we'll explore what an education IRA is, and how it differs from a 529 savings account.

Education IRA

Lorenzo is worried about the future. The costs of schools seems to be steadily increasing, and he's worried that he won't be able to provide a good education for his daughters, Maria and Consuelo. What can he do?

Many people, including parents like Lorenzo, choose to save money for college in an education IRA, also known as a Coverdell Education Savings Account, which is a tax-advantaged investment account for educational savings.

How does it work? Well, Maria and Consuelo are still very young. Lorenzo can begin putting money away every month to save for their education. If he puts the money in a normal savings account, though, the money he invests and earns will be taxed. But if he puts it into an education IRA, he'll pay taxes on the money he invests, but the earnings will not be taxed. That means his money will grow tax-free!

Lorenzo is very interested in an education IRA. But he wants to find out more. To help him out, let's look closer at Coverdell accounts and how they differ from another education savings account, the 529.

Characteristics

An education IRA sounds good to Lorenzo, but he's still kind of sketchy on the details. What does he need to know in order to invest in a Coverdell?

There are income limitations, which say that a single person with a modified adjusted gross income over $110,000, or a couple with a modified adjusted gross income over $220,000 can not contribute anything to an education IRA. In fact, as a single parent, Lorenzo will need to make no more than $95,000 to be eligible to contribute the maximum amount. (If he was part of a couple, they would need to make no more than $190,000 to contribute the maximum amount.)

So, what's the maximum amount? For children who do not have special needs, the maximum contribution limit is $2,000 per student per year until the child is 18. If he starts when his daughters are born, Lorenzo can contribute a total of $36,000 per girl. Of course, if he doesn't start until they are 8-year-olds, he'll only be able to contribute a total of $20,000.

Whatever he contributes, though, it can grow. That's because contributions to an education IRA are invested in stocks, bonds, mutual funds, or savings accounts. If Lorenzo invests his daughters' Coverdell money into good mutual funds, then he could end up with much more money in ten or fifteen years, when they're ready for college.

That leads Lorenzo to another question. How does he open an education IRA for his daughters? Most banks and investment companies will help him open the accounts and make it simple for him to automatically contribute money from his paycheck. He can check his favorite bank or investment company online, in person, or by contacting his broker.

What about when he's ready to spend the money? Well, there are some limitations there, too. First of all, the money must be used for educational expenses. If Maria decides that she'd rather buy a new car than go to college, too bad!

In addition, just as Lorenzo can only invest until his daughters are 18, they must spend all the money in the account by the time they are 30. So, Consuelo needs to make sure that she's done with her degree by then.

It's not all bad news, though. Lorenzo can use the money not only for his daughters' college education, but to pay for private school for them, as well. If Consuelo gets into a very prestigious private high school, Lorenzo can use the Coverdell to help cover the cost.

Who should invest?

A Coverdell account is a great advantage for parents, but it's not the only tax-advantaged educational savings plan. Another famous savings account for educational expenses is the 529 college savings account. By comparing the 529 and education IRA, Lorenzo can get a picture of who should invest in each of them.

Unlike the Coverdell, the 529 does not have contribution limits. That is, Lorenzo can put away as much money as he wants in a 529; he's not limited to just $2,000 per year per child. In addition, there are no age limits on a 529. Lorenzo can contribute as long as he wants, and his children can use the money at any time.

So far, the 529 sounds a lot better than the Coverdell. Why would Lorenzo even consider an education IRA if the 529 has fewer restrictions? Well, there are a couple of other differences that could be important to Lorenzo.

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