An education IRA is a special account created to pay for a child’s "qualified" education expenses. As long as their income does not exceed certain levels ($160,000 for married couples, $110,000 for singles), parents, grandparents and other individuals can make nondeductible contributions of up to $500 per year until a child reaches age 18.

Funds in an education IRA accumulate tax-free. Once the child begins attending college, he or she can withdraw funds from the IRA to pay qualified education expenses. The withdrawals are tax-free so long as they do not exceed the qualified education expenses paid. Qualified education expenses include post-secondary tuition, fees, books, supplies, equipment, and certain room and board expenses. The student need not attend full-time, but room and board will qualify only if the student attends at least half-time.

Rollovers are permitted to an education IRA for another family member, such as a younger brother or sister. However, when the beneficiary for an education IRA reaches age 30, any amount remaining in the IRA must be distributed. The earnings portion will be taxed and may be subject to a 10% penalty.

Because of the restrictive rules, education IRAs may have only limited appeal. For example, 18 years of $500 contributions invested at 8% will yield only about $20,000. Roth IRAs, regular IRAs, and non-IRA investing may give better results.