IRS Releases Guidance on Education IRA and Other Education Tax Incentives

Washington, DC, October 29, 1997 - The Internal Revenue Service has released Notice 97-60, which provides guidance on the education tax incentives enacted by the Taxpayer Relief Act of 1997 (TRA '97). In addition to addressing the Education IRA, the guidance also addresses the TRA '97 amendment to Section 72(t) that eliminated the early withdrawal tax on IRA withdrawals used to pay higher education expenses, the HOPE Scholarship Credit, the Lifetime Learning Credit, student loan interest deductions, exclusions from income for employer-provided educational assistance and qualified state tuition programs. Only the portions of the Notice addressing the Education IRA and the IRA early withdrawal provision are discussed below.

Education IRAs
The Notice provides basic information regarding the operation of the program. Most notably, Section 3 of the Notice clarifies the following:

Contributors
Any individual, whether or not related to a child and including the child him or herself, may contribute up to $500 to the child's Education IRA as long as the individual's modified adjusted gross income for the taxable year is no more than $95,000 (single)/$110,000 (joint).

Number of Accounts
There is no limit on the number of Education IRAs that may be established for a particular designated beneficiary. The aggregate annual contribution limit of $500, however, will apply across all accounts.

Excess contributions
Aggregate contributions for the benefit of a particular child in excess of $500 for a calendar year are treated as excess contributions. If the excess contributions (and any earnings attributable to them) are not withdrawn from the child's account or accounts before the tax return for the year is due, the excess contributions are subject to a 6% excise tax for each year the excess remains in the account.

The Notice does not clarify whether withdrawn excess contributions are paid to the child or to contributor(s). It also does not address who is responsible for paying the excise tax, or which individual's tax return due date (the beneficiary's or a contributor's) is relevant to determining when the excise tax becomes applicable. (A technical corrections bill, which recently was approved by the House Committee on Ways & Means, would clarify that the relevant tax return is that of the designated beneficiary.)

Tax Effects of Distribution
Generally, withdrawals from an Education IRA to pay for qualified higher education expenses are "tax-free to the designated beneficiary." Where amounts withdrawn from an Education IRA exceed the beneficiary's qualified higher education expenses in the taxable year during which the withdrawal is made, that portion of the distribution, to the extent it represents earnings in the account, is taxable. Generally, this taxable portion is also subject to an additional 10% tax. The Notice does not clarify the method by which one determines the portion of the distribution that is from earnings and, therefore, taxable.(The tax technical corrections bill would provide that distributions are treated as representing a pro-rata share of principal and earnings under Code Section 72.) Moreover, the Notice does not address who actually controls the account and makes withdrawal decisions on behalf of the designated beneficiary. (The Notice discusses distributions in terms of when the "designated beneficiary withdraws an amount" from the account.)

Rollovers and Changes of Beneficiary
Amounts distributed from an Education IRA and rolled over to another Education IRA for the benefit of the same designated beneficiary or members of the designated beneficiary's family within 60 days after the date of the distribution will not be taxable. Similarly, the same result occurs where the designated beneficiary named on the account is changed from one child to another. The terms of the trust or custodial account, however, must permit such a change in designation. The Notice explicitly permits each trustee or custodian to "control whether options like this one are available in the accounts they offer."

The Notice does not clarify whether rollovers may be made only to family members under 18 years old or may be made to family members under the age of 30. The Notice, however, discusses such rollovers in terms of their being made "from one child to another" or "to a younger sister who is still in high school."

Other
The Notice clarifies the definitions of "qualified higher education expenses" and "eligible educational institution." The Notice also addresses the relationship between Education IRA distributions and the HOPE and Lifetime Learning Credits, and between Education IRA contributions and qualified state tuition program participation.

Early IRA Withdrawals for Higher Education Expenses
Section 4 of the Notice provides guidance with regard to a taxpayer's ability to make early withdrawals from an IRA to pay for qualified higher education expenses without being subject to a 10% early withdrawal tax. Qualified higher education expenses that are paid from certain specified sources of income, rather than directly from the IRA withdrawal, may be included in determining the extent to which the 10% tax applies. Thus, where such expenses are paid with an individual's earnings, a loan, gift, inheritance or personal savings, including savings from a qualified state tuition program, such expenses may be included in determining the amount of the IRA withdrawal not subject to the 10% tax. On the other hand, such expenses, where paid with a Pell Grant or other tax-free scholarship, a tax-free distribution from an Education IRA, or tax-free employer provided education assistance are excluded from the determination.