If you're saving for higher education for your children, Congress probably got your attention by passing the new education Individual Retirement Account (IRA).
But even though it's called an IRA, you can't save this money for retirement. It's only for education and only for students who are young.
Unfortunately, education IRAs aren't as terrific as they sound. Parents may find other forms of saving more effective.
Many mutual-fund companies won't even offer education IRAs, because the size of the accounts will be so small.
These new arrangements start up next year. To help you decide whether to use one, here's some information about how they work and what your alternatives are:
With an education IRA, you can put away up to $500 a year for any child under 18. That's a total of $500, from all sources. If Mom puts up $300 for that particular child, Grandma can contribute only $200, even if it's in a separate account. Each child can have his or her own $500 IRA.
You fund these accounts with after-tax dollars, meaning you get no tax deduction. But you can withdraw the earnings tax free, if they're used for higher-education expenses.
Most parents will qualify for these IRAs if they want them. You can make the full contribution if you're single with an adjusted gross income of up to $95,000 or married up to $150,000. At higher incomes, your contribution is reduced, phasing out at $110,000 for singles and $160,000 for marrieds.
How much is this IRA worth? Say your child will be 3 next year and you start making annual $500 contributions. You earn 5 percent in the bank for the first five years (small accounts probably will have to stay in a bank), then 9 percent in stocks for the following decade. In 2012, you'll have $15,000, compared with a probable cost of $107,000 for four years in a public college. So you'll need other savings, besides.
You cannot fund an education IRA in any year you contribute to a state prepaid tuition plan for that same child. At least 14 states now offer these plans, which let you pay your child's tuition in advance and at a discount price.
In a year you use your IRA funds to pay for school, you cannot take either of the new education tax credits: the $1,500 HOPE credit for freshmen and sophomores or the lifetime-learning credit.
If the child doesn't go to college or doesn't use all the IRA money, the account can be transferred to another member of the beneficiary's family.
If the IRA hasn't been emptied when the beneficiary reaches 30, however, all the remaining funds have to be withdrawn. At that point, the earnings will be taxed, with a 10 percent penalty tacked on.
Education IRAs can be funded in addition to true retirement IRAs, be they the traditional, tax-deductible accounts or the new Roth IRAs that will accumulate tax free. But you can't roll money out of a retirement IRA and into an education account.
Congress did add a sweetener to retirement IRAs. Starting next year, you can take money out of these accounts and use it for higher education. You'll have to pay income taxes on the withdrawal, but not the usual 10 percent tax penalty if you're under 59 1/2 .
With all these IRA options, what's your best strategy for college?
1 -- If your child is very young and you want to take the chance that the education IRA will last, fund it faithfully every year and invest in a high-yielding asset. When your child is in college, use up all the money in a single year.
Your IRA will have earned more than you'd get from the tax credit for education (another goodie which may or may not exist when your child enters school). Once you've emptied your education IRA, you can use the tax credits in subsequent years.
2 -- If you're sure that your child will go to school in-state, and your state has a prepaid tuition plan, use that instead of the education IRA. These plans allow you to put away larger amounts of money every year.
3 -- If you have a true retirement IRA, try not to tap it for education. Money removed from this excellent tax-sheltered account can never be returned. Consider borrowing extra money for college instead.