The Education IRA is a
creation of the same 1997 tax law that gave birth to the Roth IRA, the education tax
credits, and the deduction for student loan interest. The Education IRA offers a direct
challenge to the QSTP, which has been around in the tax law for a year longer, because
contributions cannot be made to both in the same year for the same beneficiary.
.In almost all situations, a better result will be obtained with
a QSTP than with an Education IRA. Some taxpayers will not even be eligible to use an
Education IRA. A taxpayer with modified AGI exceeding $160,000 (for joint filers), will be
unable to contribute to an Education IRA. If the designated beneficiary is over 17 years
old, a taxpayer will be unable to contribute to an Education IRA. If a taxpayer wants to
save more than $500 per year, he/she will not be able to do so with an Education IRA. In
each of these situations, a QSTP remains a viable option.
Lets assume that Harry is eligible to use an Education IRA and
can afford to put away $5,000 for his daughters future college expenses. She is
eight years old and expects to enter college in ten years. Surely, he thinks, the
Education IRA is better than the QSTP because the earnings in an Education IRA are tax
exempt, and the earnings in a QSTP are merely deferred until the year withdrawn for
If Harry elects to use an Education IRA, he may contribute $500 per
year which will grow to a fund of $7,825 after ten years if we assume an investment return
of 8%. We also assume that the funds awaiting contribution because of the $500 limitation
are placed in a taxable investment account earning 8% pre-tax and 5.76% after-tax (using
his 28% federal tax bracket). Harry will have an additional $1,861 in earnings from this
account after ten years. In total he will have $9,686 ($7,825 plus $1,861) available after
ten years to pay for qualified higher education expenses.
If Harry instead uses a savings-type QSTP, he will be able to
contribute the entire $5,000 in the first year. Assuming an investment return of 8%, his
account will grow to $10,795 after ten years. The withdrawal for qualified higher
education expenses will be taxable to his daughter, who will likely be in the 15% federal
tax bracket. Federal tax of $869 will be produced, reducing the available funds to $9,926.
This is $240 more than the Education IRA.
Theres more. The withdrawals from the QSTP used for qualified
higher education expenses will qualify for the HOPE Scholarship Credit or the Lifetime
Learning Credit. This will produce an additional benefit of at least $1,500 (the current
cap of $1,500 on the HOPE Scholarship Credit will increase with inflation). Tax-free
withdrawals from an Education IRA disqualify the beneficiary from claiming the HOPE
Scholarship or Lifetime Learning Credit in the same year.