Paying For Education: Provisions in the New Tax Act

October 24, 2001 Advisory

Recent years have seen the cost of education, particularly at the post-secondary level, rise to staggering levels, outpacing inflation and income growth. The new tax act includes specific provisions addressing the ways in which taxpayers can get an early start on financing a child's education, two of which are addressed below.
Education IRAs. Under the existing law, taxpayers may contribute to an Education IRA up to $500 per beneficiary per year until the beneficiary attains age eighteen (18). The contribution limit is phased out depending on the contributor's adjusted gross income. The funds in the IRA must be used for qualified higher education expenses. Higher education in this context means post-high school.
The new tax act makes Education IRAs more attractive by increasing the amount of annual contributions one can make to each beneficiary and by expanding the definition of qualified education expenses. Beginning in 2002, individuals may make annual contributions of up to $2,000 per beneficiary, and qualified education expenses will include elementary and secondary school expenses. In addition, the Act authorizes corporations to make contributions to Education IRAs, and increases the phase-out range for married contributors filing jointly to $190,000 - $220,000 (i.e., double that of single taxpayers).
Qualified Tuition Programs (Section 529 Plans). Existing law provides that individuals may establish an account under a State operated program on behalf of a beneficiary to be used for the beneficiary's qualified higher education expenses (e.g., tuition, room and board, books, school fees and supplies). The contribution is considered a completed gift and, therefore, the donor may use his or her annual gift tax exclusion amount ($10,000 per recipient) to avoid gift tax liability. Furthermore, the account may be "pre-funded" with up to five years of annual exclusion gifts, which may result in a higher total return on the investment. The accounts grow on a tax-deferred basis; earnings are taxed only upon distribution, at the student's income tax rate (a rate usually much lower than that of the contributor). The beneficiary may be changed at any time.
The new tax act removes the requirement that the contribution be made to a program established and maintained by a State. Instead, beginning in 2002, contributions may be made to programs of "eligible educational institutions," which include private schools, colleges and universities. In addition, beginning in 2002, distributions from State programs will no longer be subject to income tax, provided the distributions are used to pay qualified higher education expenses. This income tax rule will apply to privately run programs beginning in 2004.