The Education IRA Should Be Expanded and Simplified.

The Education IRA--created by Congress in 1997--is an important first step in encouraging American families to save for post-secondary education. However, the current $500 contribution ceiling is too low for families to save enough to meet the growing costs of higher education. In addition, complex rules undercut the effectiveness of the Education IRA as a savings vehicle.

More needs to done to encourage education savings. The Education IRA could be a critical tool for accomplishing this goal, if the amount that can be contributed is increased and the rules are simplified.

The average annual cost at a four-year public college is now $10,069 per year, and is expected to rise by 5 percent or more per year. By 2016, that cost could top $25,000 per year. For most American families, savings are not sufficient to cover the costs of higher education.

Significantly, tuition increases have consistently outpaced growth in family income. After adjusting for inflation, tuition increases from 1980 to 1995 approached 100 percent for both public and private four-year institutions. In contrast, median income for those families most likely to have children in college has risen only 9 percent since 1980, after adjusting for inflation. According to the U.S. Department of Education, between 1985 and 1995, tuition, room, and board at public institutions increased from 11 percent to 15 percent of median family income. For families with children in a private institution (or who pursue postgraduate education), higher education costs will consume an even greater share of family income.

Today, most families fund college education through a combination of "pay-as-you-go" financing and "pay-after-you-go" student loans. Others deplete retirement savings to pay for children’s college expenses. Even among those families who do save something for higher education, many do not set those funds aside in a separate account. All too often, those non-segregated savings are used for other, more immediate, needs.

Funds in an Education IRA are segregated from other family assets and there are substantial disincentives for non-education withdrawals. This means college savings are much more likely to be used for college. In addition, the favorable tax treatment of Education IRAs, and the "miracle of compounding" within the account, provide a meaningful incentive for families to set aside funds for their children's education.

The $500 annual Education IRA contribution is not adequate to provide a meaningful offset for college costs, and is not indexed for inflation despite the fact that college costs are increasing at a rate greater than inflation.

If the maximum $500 annual contribution were made each year to an Education IRA for a child born today, that child would have only about $17,000 by the time he or she reached college age in 2016 -- an amount that would cover just more than one semester's tuition, room, and board at an in-state public institution. In order to meet the education savings needs of American families, the annual Education IRA contribution limit must be increased substantially and indexed for future inflation.

Congress should also allow parents to make "catch-up" contributions to Education IRAs to help offset those years in which no contributions were made. Until 1998, Education IRAs were not available. For families with children who are already teenagers, even a higher Education IRA contribution limit will not be sufficient. In addition, many families cannot save continuously for their children's college education because of temporary unemployment, illness, or a decision to forego income to stay home with the children. These families would be helped by a rule that allowed additional Education IRA contributions for older children. To ease administration of the rules, a simple catch-up rule could be targeted to the period when the family is most focused on impending education costs (e.g., when the child is age twelve or older).

The current rules governing Education IRAs are unnecessarily complex. That complexity, in turn, results in reduced contributions. Three basic changes would substantially simplify the Education IRA and increase its effectiveness.

First, the experience with complex eligibility rules that were imposed on IRAs in 1986 shows that such rules are counterproductive. Although the intention may have been to take the IRA away from more affluent households, in fact, IRA contributions dropped by more than 40 percent for those who continued to be eligible. The complex eligibility restrictions scared people away. Similarly, the current rules that limit eligibility to contribute to an Education IRA depending on the contributor's income should be eliminated because they reduce saving at all income levels.

Second, the current rule that requires that all Education IRA contributions be made by December 31 of the taxable year should be modified. For all other types of IRAs, an individual can make a contribution through the due date of his or her federal income tax return. The more stringent deadline for Education IRAs creates significant confusion. Also, the general IRA approach to the timing of contributions has proven very successful. A substantial portion of total IRA contributions occur after the close of the year. Many taxpayers who receive income tax refunds and year-end bonuses in the period between the close of the year and April 15th use those funds to make IRA contributions. Individuals should be given the maximum opportunity to save by conforming the deadlines for Education IRA contributions to the rules that apply to other IRAs.

Third, under the rules in effect today, if the HOPE or Lifetime Learning credit is claimed with respect to a beneficiary for the year in which the Education IRA withdrawal is made, then the Education IRA loses its tax-advantaged treatment. This is true even if the family is entitled to a HOPE credit or Lifetime Learning credit with respect to some college expenses and the student is making the Education IRA withdrawal to pay other expenses. For the Education IRA to be successful, individuals making contributions need to know with considerable certainty that they will get the tax benefit if they use the account to cover college costs. As a result, the current rule denying all tax advantages to Education IRA withdrawals in any year in which HOPE or Lifetime Learning credits are claimed should be replaced with a narrower rule which would deny the use of both vehicles to cover the same costs.