Ask the Dollar Diva By Dorothy Rosen • Bankrate.com

Education IRAs

Dear Dollar Diva,
I have the following questions regarding the Education IRA:

1. Is a contribution to the Education IRA tax deductible?
2. Does an Education IRA generate tax-free income?

Doris

The answer to the first question is a disappointing "no." Your Education IRA contribution is not deductible; it's paid out of after-tax dollars. The answer to the second question is an encouraging "yes." The income accumulates tax-free, and remains tax-free forever as long as it's used for higher education expenses.

Why is it called an IRA?

The IRS goofed when it labeled this kind of an account an "IRA." It has nothing to do with an Individual Retirement Account; the term is misleading. So don't worry; contributions to Education IRAs have no affect on contributions made to other IRAs, and vice versa.

Education IRA rules

Will the Education IRA work for you? The Diva will provide you with the various limitations and rules so you can decide for yourself:

• Maximum annual contribution per eligible child is $500. An eligible child is anyone under 18 years of age.

• Annual contribution must be made by December 31^st of the calendar year. You don't have until April 15^th of the subsequent year, like you do with a regular retirement IRA.

• Anyone can contribute to an Education IRA: parents, aunts, uncles, friends, or even the eligible child himself.

• If you take an education credit, you can't use an Education IRA that year. Visit the IRS Web site for more information on education credits: HOPE Credit and Lifetime Learning Credit. They're wonderful tax breaks.

• High-income folks may not be able to make a contribution. The phase-out occurs for joint filers with modified adjusted gross income between $150,000 and $160,000; for single filers, between $95,000 and $110,000. But they can give a cash gift of $500 to someone with less income, and ask him to make the contribution instead.

• A child cannot have contributions made to both an Education IRA and a qualified state tuition program (QSTP) in the same year. It's an either/or deal.

• There's a six percent "excess contribution" tax if more than $500 is contributed for the same child, even if the contributions are made by different people. This punitive tax also kicks in if a contribution is made to an Education IRA and a QSTP for the same child in the same year. For more on this see IRS Publication 590, Individual Retirement Arrangements (IRAs) (including Roth IRAs and Education IRAs)

The Diva would like to see parents and students focus on "savings" rather than "student loans" to fund college costs. If you can afford to save more than $500 a year for education, investigate qualified state tuition programs.

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.