Updated June 2007

The vast majority of taxpayers will agree that, regardless of the order of priority, retirement planning and education financing are their two most important financial-planning items. Funding our retirement plans is encouraged by the convenience of contributions through automatic salary deductions, the income-tax deductions allowed for some contributions and the tax-free growth for some others.

Consequently, we often fund our retirement plans on a consistent basis while financing the education accounts of our children is usually placed on the list of items "we will get to later". With the constant rise in cost of higher education you will want to make sure that at least a portion of your children's education expense is covered. You will be happy to know that there are several means of funding education accounts for your children, and ways to help them save for their retirement.

Roth and Traditional IRA for Minors
If your child is a minor and earns income from babysitting, paper routes, assisting mom and dad in the store, and the like, he or she may use the income from those jobs to fund a Roth or Traditional IRA. This will not only give your child a head start on saving for his or her retirement years, but also start cultivating healthy saving habits at an early age. The following are some considerations that apply to your child's IRA.

Contribution Limits and Eligibility Requirements The contribution limits and eligibility requirements are the same for adults and children who are minors. (To learn more, see Traditional or Roth IRA... Which Is the Better Choice?) For example, a minor is allowed to contribute up to 100% of compensation or the dollar limit in effect for the year - whichever of the two is less- to his or her Roth or Traditional IRA . A minor whose income is subjected to income tax may reduce the taxable amount by making a deductible contribution to a Traditional IRA. Refer to IRS Publication 929 for information on the tax rules for children. (Check out the Traditional IRA Tutorial for more on IRA contribution limits.) Legal Issues State laws generally prohibit minors from entering into contracts, which means that a minor cannot establish the IRA him/herself. The parent or legal guardian will sign adoption agreements and other legal documents on behalf of the minor. The IRA should be titled to include the name of the adult and the minor in a way that it is clear who is the minor and who is the guardian. The account is usually transferred to the name of the child when he or she reaches the age of majority as defined by the state of residence.   Distributions Except amounts for which no deduction was allowed or taken, distributions from IRAs are treated as ordinary income. For Traditional IRAs, earnings and amounts representing deductible contributions are treated as ordinary income when distributed, and they may be subjected to early-distribution penalties unless certain exceptions apply. (See Taking Penalty-Free Distributions from Your IRA.)Qualified distributions from Roth IRAs are tax and penalty free. (To find out more, see Tax Treatment of Roth IRA Distributions.)     Investment Options The investment options for Roth and Traditional IRAs vary depending on the financial institution with which the account is maintained. These investment options include, stocks, bonds, mutual funds, certificate of deposits and money markets. Make sure you conduct a thorough research and consult with your financial planner to ensure that the investments you choose are compatible with risk tolerance and financial profile.

Education Savings Account (Formerly Known as Education IRAs)
The Education Savings Account (ESA) is usually established to finance the education of the designated beneficiary*. Prior to 2002, eligible expenses included only those incurred while the child attended an eligible higher-education institution. For tax years beginning 2002, qualified education expenses include certain elementary and secondary education expenses, as well as certain expenses for special-needs students**. Eligible expenses include student-activity fees, fees for course-related books, supplies, equipment and some boarding fees.
 
While contributions to the ESA are not deductible, the earnings do accumulate on a tax-free basis, provided distributions are used to cover qualified expenses. For amounts withdrawn that are not used to cover qualified expenses, the earnings will be treated as ordinary income and may be subject to a 10% early-distribution penalty for beneficiaries under age 59.5.

Similar to the deadlines for making contributions to Roth and Traditional IRAs, the deadline for making a contribution to an ESA for one year is Apr 15 the following year.

Contribution Limits Beginning tax year 2002, the annual contribution limit for the ESA was increased to $2,000 per beneficiary (up from $500). Should you decide to fund ESAs for multiple beneficiaries, you may contribute up to $2,000 for each beneficiary. If multiple individuals contribute on behalf of one beneficiary, the total contributions cannot exceed $2,000, even if multiple ESAs are established for the beneficiary. It is therefore important that the different individuals who are funding ESAs for one beneficiary communicate their decisions with each other. Who Can Contribute to an ESA? One of the most attractive features of the ESA is that anyone who meets certain income requirements can contribute to the account on behalf of the designated beneficiary. This includes aunts, grandparents, parents, friends and even the beneficiary him/herself. In order to contribute to an ESA, the contributor is not required to have income. Should, however, an individual's income exceed certain limits, he or she is not eligible to contribute to an ESA. If the contributor is married and files a joint income tax return, he or she cannot contribute to an ESA if his or her modified adjusted gross income (MAGI)*** is $220,000 or more. The limit of $2,000 is gradually reduced once the MAGI falls into the range of $190,000 to $220,000. For other taxpayers who are not married or file a joint income-tax return, the range is between $95,000 and $110,000, so individuals whose MAGI is $110,000 or more are ineligible to contribute to an ESA. Contributions that exceed the $2,000 limit or contributions made by individuals who exceed the income limits stated above are considered excess contributions and could be subjected to IRS penalties. Portability Among Family Members If the original designated beneficiary does not use the funds in the ESA, all is not lost since the assets can be rolled over to one of the designated beneficiary's family members who is under age 30. To allow flexibility, the IRS defines the following as the family members to whom the beneficiary's assets can be re-designated: Son or daughter or their descendants Stepson or stepdaughter Brother, sister, stepbrother or stepsisters Father or mother or ancestor of either Stepfather or stepmother Son or daughter of a brother or sister Brother or sister of father or mother Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law The spouse of any individual listed above First cousin Age Limitations Unless the beneficiary is a special-needs beneficiary, contributions can no longer be made on his or her behalf after age 18, and the assets must be distributed within 30 days after his or her 30th birthday. If the distribution is not used for qualified expenses or rolled over to the ESA of a family member who is under the age of 30, the earnings will be treated as ordinary income and may be subjected to a 10% early-distribution penalty. Investments The Investment options for an ESA are similar to those of Traditional and Roth IRAs.

Qualified Tuition Programs & 529 Plans
Qualified tuition programs (QTP) and 529 plans are established to allow you either to prepay or contribute to an account established for paying the beneficiary's higher education expenses at certain institutions. Check with your financial institution or with the educational institution to determine expenses that qualify. Your child's QTPs/529 Plan may be established and maintained by a state, an agency of the state, or by an educational institution.

No Age/Income Restrictions Unlike the ESA, QTPS, and 529 plans do not have age or income restrictions. Although the plans are offered by individual states, there is no residency restriction, which means that if you live in one state, you are allowed to participate in a QTP offered by another state. Contributions For QTPs, the maximum contributions is the amounts required to cover the eligible educational expenses of the beneficiary. For 529 plans the limits vary among state plans, with some being as high as $235,000. Some states even allow their residents tax deductions for contributions made to the plan. A growing number of employers are forming relationships with QTPs and 529 providers so that contributions can be made through payroll deduction. For many, monthly contributions are as little as $15. If you are interested in participating in a salary deduction program for funding these plans, check with your employer regarding their participation status. Distributions For most QTPs plans, earnings accrue on a tax-deferred basis, and distributions used for qualified dispenses are tax-free. The qualified expenses are similar to those of the ESA. To be sure, check with the plan provider for a list of eligible expenses. Investments The investment choices for QTPs are usually limited to mutual fund or annuities. For some plans, the investment choices are based on the age of the beneficiary. The more aggressive investments are targeted at younger beneficiaries.   Portability Among Family Members Similar to the ESA, the QTP and 529 plans may be transferred to a family member.

Conclusion
Be sure to compare the features and benefits of the different plans, and choose the one that best suits your financial goals for your child's education. Finaid.com provides a checklist that you may find helpful for choosing the right education savings plan for your child.

The plans discussed here are by no means an exhaustive list. The following are some websites that provide helpful information on savings for children:

http://www.savingsbond.gov provides information on saving bonds. One of its extensions, http://www.savingsbond.gov/sav/savkids.htm, provides information in a simple and interactive format specifically targeted at children. This website also includes a four-lesson curriculum supplement that addresses mathematical concepts using real-world financial scenarios - teachers of mathematics and other financial subjects may find this useful. http://www.finaid.org provides information on UTMA and UGMA Custodial Account. This site also includes custom calculators that you may use to help you figure out how much your child's education will cost and information on other types of financial aid. http://www.ed.gov provides information on financial aid, grants and contracts and information on education resources.

Of course, there are always the good-old student loans and tax credits that you may claim for educational expenses. When you look into these options, remember that you too may meet the eligibility requirements - just something to consider for those of you who plan to continue your education.

Notes:
* For Education Savings Accounts and 529 Plans, the term beneficiary refers the individual for whom the account is established and maintained.
** The term “special needs” is generally used in reference to a student, who because of a physical, mental, or emotional condition (including learning disabilities) require additional time to complete his or her education.
*** For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return. Your tax professional can help you determine your MAGI.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.