n June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001, a package of sweeping tax reforms affecting income, estate and gift taxes. Some of the new provisions ease the costs of higher education by providing new and expanded deductions and exclusions. This article explains the new rules on education IRAs. To better serve clients, CPAs should familiarize themselves with these more liberal rules.
The Taxpayer Relief Act of 1997, Section 213(a), created code section 530, allowing a taxpayer to establish an education IRA—a trust or custodial account to pay a single named beneficiary’s qualified education expenses (QEEs). Annual contributions were limited to $500 per beneficiary per year. The annual contribution limit was phased out for single filers with $95,000 to $110,000 of modified adjusted gross income (MAGI) ($150,000 to $160,000 if married filing jointly). Contributions had to end when the beneficiary reached age 18.
QEEs were expenses incurred for undergraduate- or graduate-level course work, and included tuition, fees, books, supplies and equipment. The definition included room and board if the beneficiary was at least a part-time student, limited to (1) $1,500 per academic year for students without dependents living at home with parents or guardians, (2) the institution’s normal charge for students without dependents living in institution-owned or –operated housing, or (3) $2,500 for the academic year for all other students. QEEs also included amounts paid or incurred to purchase tuition credits or make contributions to a qualified state tuition program (QSTP) for the education IRA beneficiary.
As originally conceived, contributions to an education IRA were made after-tax; distributions were taxed under the code section 72 annuity rules. Distributions thus consisted of contributions and earnings that might be subject to tax, depending on the amount of QEEs. A taxpayer determined the nontaxable portion of a distribution by multiplying the distribution by the ratio the total contributions bore to the account balance when the distribution was made, under code sections 72(e)(9) and 530(d). Earnings were generally not taxed until distribution, and were excluded from income to the extent used to pay QEEs. A beneficiary had to include in income distributed earnings not used to pay QEEs and generally was subject to a 10% penalty.
Under code section 530(d)(5), unused education IRA balances could be rolled over tax-free into education IRAs created for other family members and did not count toward the $500 limit. Account balances remaining after a beneficiary reached age 30 were deemed distributed within 30 days of the date that age was reached. If the beneficiary died before reaching 30, the distribution had to be made within 30 days of death, according to code section 530(b)(1)(E).
If the beneficiary claimed an exclusion under the education IRA provisions, neither the HOPE credit nor the lifetime learning credit could be claimed for the same tax year. The exclusion had to be waived to claim these education credits, under code section 25A(e)(2).
In addition, a 6% excise tax applied to excess contributions to an education IRA, under code section 4973 (that is, contributions for the tax year that exceeded the allowed limit—$500—or that were also contributed to a QSTP program for the same beneficiary).
NEED FOR CHANGE
Critics complained that the annual $500 contribution limit was too low and did not match rising education costs; further, the low contribution limit stopped many banks and brokerage houses from offering such accounts, as their administrative costs were not covered.
Under the new act’s section 401(a)-(g), the maximum annual contribution to an education IRA is increased to $2,000; taxpayers may now also use the accounts for elementary and secondary education expenses, whether incurred in a public, private or religious school. Additional amendments
End the MAGI-limit marriage penalty.
Permit contributions for special-needs beneficiaries over age 18 and allow their accounts to continue after age 30.
Clarify that entities can be contributors.
Lengthen the contribution period until the return due date.
Extend the time for returning excess contributions.
Coordinate the education credit and QSTP provisions.
Maximum yearly contribution: This ceiling is increased from $500 to $2,000, for tax years beginning after 2001 (code section 530(b)(1)(A)(iii)). When contributions for the year exceed $2,000, the taxpayer faces a 6% excise tax. Families with more than one child can roll over unused portions of an education IRA for a younger child’s use.
No marriage penalty: The MAGI used to determine the contribution limit phaseout range for married taxpayers filing jointly is increased to twice the amounts applicable for single filers, eliminating the marriage penalty aspect. Thus, the $2,000 annual contribution limit is phased out for joint filers with MAGI of $190,000 to $220,000 ($95,000 to $110,000 if single). Contributions from entities (for example, corporations) are not subject to the phaseout rules. Thus, individuals subject to the phaseout rules should have a child, friend, relative or corporation, trust or other entity make the contribution.
Elementary and secondary education: These expenses can now be paid for with education IRA distributions. Specifically, QEEs include expenses incurred while the beneficiary attends or is enrolled at an elementary or secondary school (that is, grades K-12, as defined by state law), whether public, private or religious.
Such expenses include tuition, fees, books, supplies and equipment and costs for special-needs services of a special-needs beneficiary. Qualified elementary and secondary education expenses differ, however, in that they include expenses for
Purchase of computer technology or equipment (as defined in code sections 168(i)(2)(B), 170(e)(6)(F)(i), 197(e)(3) (B) and 530(b)(4)(A)), Internet access or related services.
Room and board, uniforms, transportation and supplementary items and services required or provided by the school (as defined in code sections 529(e)(2), (e)(3)(B)(ii) and 530(b)(2) (A)(i)).
QSTP contributions: Contributions made to a QSTP under code section 529(b) are deemed QEEs payable from an education IRA. Any contribution a taxpayer makes with tax-free earnings is not taken into account under the code section 72 annuity rules.
Special-needs beneficiaries: Treasury has been granted the authority to issue regulations allowing contributions to an education IRA to continue past age 18 for a special-needs beneficiary, and for distributions to continue and rollovers to occur past age 30. They would apply to an individual who, due to a physical, mental or emotional condition (including a learning disability) requires additional time to complete an education.
Timeliness issues: A taxpayer can make contributions by the return due date (without extensions) for the tax year of the contribution. Thus, a calendar-year taxpayer would have until April 15, 2003, to make a 2002 contribution. The contribution is deemed paid on the last day of the tax year (here, December 31, 2002).
The new law extends the time for making corrective withdrawals of excess contributions. The 10% penalty tax and the 6% excise tax on excess contributions will not be imposed if distributed by May 30 following the tax year of the contribution. The distribution must be accompanied by the net earnings thereon.
Education credits and QSTPs: A student can take advantage of the education IRA provisions, as well as the HOPE and lifetime learning credits and a QSTP, in the same tax year. A beneficiary no longer needs to waive tax-free treatment for distributions from an education IRA to use education credits during the same tax year; instead, the taxpayer must elect not to claim the education credits for qualified tuition and related expenses paid during the tax year, according to code sections 25A(e) and 530(d)(2)(C); further, no 6% excise tax will apply.
In determining QEEs payable from an education IRA, total QEEs are first reduced by scholarships or fellowships excludible from income under code section 117 and any other tax-free educational benefits. QEEs are then further reduced for amounts taken into account in determining the education credits under code section 25A. If a student receives distributions from both an education IRA and a QSTP under code section 529 that together exceed these remaining expenses, the expenses must be allocated between the distributions.
CPAs should advise clients that, under the act’s section 401(h), the new provisions apply to tax years beginning after 2001. All act provisions cease to apply to tax years beginning after 2010.
—Lesli S. Laffie, JD, LLM