The 1997 Taxpayer Relief Act states that the new educational IRA is a trust or custodial account created exclusively for the purpose of paying "qualified higher education expenses" of the designated beneficiary. The maximum contribution cannot exceed $500 a year and must be made before the beneficiary reaches age 18. Distributions from the IRA when used for higher education expenses will not be subject to income tax.

If you set up an Educational IRA at the birth of a child and the fund earns 11 percent (the average of the stock market for the last 72 years) when the child is 4 years old, the initial $500 and subsequent $500 contributions, the fund would have a value of $2614, the earnings would be $614. Held for 18 years with contributions for 18 years the value would be $27970, earnings would be $18970 and that would be tax free if used for higher education expenses. In the year a parent uses the educational IRA earnings to pay for higher education, they can not use either the Hope Tax credit or Lifetime Learning credit.

A child's education fund, if it is in the form of an UTMA, (Uniform Transfer to Minor Act account) where you are the custodian of the fund until the child reaches the age of majority, can be used for the welfare of the child. An UTMA is taxable at the parent's tax rate until the child reaches 14 then it is taxed at the child's rate. So you can use that fund for preschool, camp, private education etc. You can not use it for the everyday incidentals you, as a parent, would be responsible for such as groceries, clothes etc.

-- Answered by Dee Lee, CFP, MBA, certified financial planner & author, Harvard Financial Educators