While many doctors have the best of intentions to save for their children’s education, things don’t always work out that way. The problem for many doctors is that when tuition and expense bills come due, a lot of money is immediately required that a doctor may not have on hand.
Here are three options that doctors with limited educational savings can do to fund education when they don’t have time to save. Due to the complexity of the strategies, it is important to consult with a tax advisor before implementing any of them.
Gift assets and shift rental or lab income
Do you not have enough cash flow to fund education as well as handle current expenses? A doctor can transfer his or her personally-owned office building and/or equipment into a partnership entity, and thereafter lease the property back to the professional corporation at the highest reasonable rental rate. Once established, the doctor can transfer the vast majority, typically 95%, of the nonmanaging ownership interests in the LLC/FLP to his or her college-age children in order to shift taxable income to their returns.
While the “kiddie tax” can be a factor, if the college-age children generate at least 50% of their support (net of scholarships received) from their own earnings, including practice-earned wages, the “kiddie tax” does not apply. This means that all unearned income, including the LLC/FLP income, can also be taxed at the child’s rate, which is at a 10% to 15% federal income tax rate or up to $37,950 of taxable income in 2017.
While most doctors will pay federal income tax at a 15% rate (or 20% if taxable income exceeds $415,050 if single or $466,950 if married) on capital gains and dividends, some family members may qualify for the special 0% tax rate. Dividends and capital gains are tax-free for those in the lowest (10% to 15%) tax brackets. This includes single individuals whose taxable income (after all itemized and standard deductions and personal exemptions) does not exceed $37,950.
Doctors can use this strategy to help fund their college-aged children’s education costs on a tax-deductible basis. Doctors can gift appreciated assets, such as stocks, bonds, and real estate, to their children. The same “kiddie tax” rules apply as they do in the above example, so children under age 23 need to have earned income that is equal to more than 50% of their support. This can be accomplished by paying children for meaningful marketing tasks in the practice that can be completed remotely. Accordingly, the capital gains and dividends generated will be tax-free to these low-bracket children up to the level set forth above. They can use these tax-free proceeds to meet educational and other personal living expenses.
Refinance student loans into a home mortgage
When a doctor is required to take out student loans for a child, interest rates on those loans are typically very high. Rather than being held captive to student loan interest rates, we recommend refinancing the loans into home mortgages, which dramatically decreases the interest rate. Additionally, where student loan interest is typically not tax-deductible for a doctor due to the doctor’s income level, interest on a home mortgage is deductible on the itemized deductions on the doctor’s 1040 (subject to certain limitations). This allows doctors who require a longer payoff period to dramatically decrease the cost of borrowing compared to traditional student loans.
Andrew Tucker, JD, CPA, CFP, and John K. McGill, JD, MBA, CPA, provide tax and business planning for the dental profession and publish the McGill Advisory newsletter through John K. McGill & Company Inc., a member of McGill & Hill Group LLC, dentists’ one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. Visit mcgillhillgroup.com.