By John K. McGill, JD, CPA, MBA, and Brett Miller, CPA, CFP®
While college costs continue to escalate at a rate much faster than inflation, scholarships and grants have declined, leaving doctors to shoulder a larger portion of their children's educational costs. In order to get the biggest bang for their buck, doctors need an educational funding strategy that offers tax-deductible savings, tax-deferred accumulation, and tax-free payouts, while maximizing the use of all available tax credits and deductions. If properly implemented, our tax-savvy approach can provide all necessary college funding while saving doctors over $50,000 per child in federal and state income taxes!
How much college funding to provide?
Until about 10 years ago, most doctors planned to provide 100% of the funds required for their children's college education. That thinking has since changed. Now, most doctors want their children to participate in the college funding process, by providing at least 25% to 50% of the expected cost through scholarships, loans, and/or earnings. While it may come as no surprise, children with some "skin in the college funding game" attend class more regularly, make better grades, and graduate more quickly than those whose parents provide a full ride.
Employing your children
So what is the best way to generate tax-deductible savings? The Tax Court has allowed deductions for salaries paid to children as young as age 7 (Eller vs. Commissioner, 77 TC 934 [1982]). Accordingly, we recommend that doctors begin employing their children through the practice and paying them the maximum reasonable tax-deductible salaries in exchange for their services rendered beginning at age 6. Each child can earn up to $6,100 in 2013 and pay zero federal income taxes, while qualifying for a Roth IRA contribution. Each year thereafter, the child's salary should be increased to reflect his or her increased age and responsibility.
Investing salary proceeds
Once a child is on the payroll, doctors should deposit the wages into the child's custodial checking account, with one parent named as custodian. Thereafter, the doctor should invest the salary proceeds in a Coverdell Savings Account (CSA) for the child first, up to a maximum of $2,000 annually, with the remaining funds contributed to a Roth IRA, up to $5,500 annually. Funds contributed to a CSA grow tax deferred, and can be distributed tax-free for educational purposes.
Funds contributed to a Roth IRA are nondeductible, but they grow tax-free and can later be distributed without taxes or penalties to pay for qualified educational expenses. This is the single greatest advantage of contributing to a Roth IRA as opposed to following the traditional financial planning advice, which says to invest all funds in a 529 plan. Funds not needed for educational purposes can continue to grow tax free inside the Roth IRA without penalty, and can be withdrawn tax free after age 59½ without penalty. In contrast, funds withdrawn from Section 529 plans, but not used for educational purposes, are subject to federal and state income taxes and penalties.
Paying for college
When the child reaches college age, distributions should be made in the reverse order of contributions. The continuing salary from the practice should be used first to fund college expenses, with the balance coming from withdrawals from 529 plans, then CSAs, and finally from the Roth IRA. If additional funds are needed, doctors can gift a portion of the ownership interest in an LLC/FLP to their college age children.
Maximizing education tax credits
Lastly, doctors should remember to take full advantage of the two education tax credits available in order to maximize their tax savings. The American Opportunity Tax Credit provides an annual tax credit of up to $2,500 for each of the first four years of college, with $1,000 of the credit being refundable. The Lifetime Learning Tax Credit remains available up to $2,000 per year for each year of graduate and professional school thereafter. Since both credits are subject to AGI phaseouts that eliminate their use by most doctors, we recommend that the child claim these tax credits on his or her return in order to offset any federal income tax otherwise due.
With college costs going nowhere but up, doctors need to make sure that every dollar counts. Doctors who save and pay for college by using these recommendations can ensure they will have the funds necessary to meet their children's college, graduate, and professional school expenses, while saving over $50,000 per child in federal and state income taxes!
John McGill provides tax and business planning services exclusively for the dental profession and publishes The McGill Advisory newsletter through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC. Brett Miller provides investment advice through Select Consulting, Inc., a Registered Investment Advisor and affiliate of the McGill & Hill Group, a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment management services. For more information regarding education funding, visit www.mcgillhillgroup.com/webinars.asp.
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