Marvin Appel, MD, PhD, and Brian Hufford, CPA
Paying for college continues to become increasingly difficult. Recent federal government statistics put the latest one-year tuition increases for four-year public colleges at 9.6 percent, while private college tuitions jumped 5.8 percent. This occurred during a year when inflation was only 1.2 percent! Unfortunately, these figures are not exceptional. Since 1982, college tuitions have outpaced inflation by more than 4 percent each year. (Per capita income has grown by 2.2 percent per year above inflation during the same period.)
The cost of tuition, room, and board at four-year schools now averages $11,000 per year at public colleges and $27,000 per year at private colleges. Top private schools cost $42,000 per year. What can you do to prepare for the staggering cost of sending your children to college?
The federal tax code offers two tax breaks specifically for college savings: the Coverdell Education-Savings Accounts (formerly known as education IRAs) and 529 plans. However, last year's tax cuts provide a third viable option — tax-oriented investment strategies.
Education-savings accounts offer the greatest flexibility and potentially lowest costs. They function like Roth IRAs in that you contribute after-tax dollars to them, but the investment gains are compounded tax-deferred. Like Roth IRAs, you can open an education-savings account through virtually any mutual fund and enjoy the maximum investment flexibility.
Under current tax law, investment profits will not be taxed if withdrawn to pay for "qualified educational expenses at an eligible educational institution." In practice, this means tuition, books, fees, tutoring and — if the attendance at school requires it — room and board for accredited schools from elementary until the beneficiary reaches age 30. In Chapter 7 of IRS publication 970 (www.irs.gov), you will find a surprisingly readable description of education-savings accounts.
There are two principal limitations on education-savings accounts. First, each child can receive a combined total of only $2,000 per year from all donors. Second, an individual with an income over $110,000 ($220,000 if married and filing jointly) cannot contribute to an education-savings account. This income limit prevents many dentists from enjoying the benefits of education savings.
As a result, many of you should rely most heavily on 529 plans. Unlike Education-Savings Accounts, 529 plans are available to everyone, regardless of income. Also, the amounts you are allowed to contribute are far higher for 529 plans than for education-savings accounts, with limits in some states reaching $300,000 per beneficiary (future student).
Each state sponsors its own 529 plans with its own investment selections, expenses, and rules. Some states, such as New York, offer state income tax deductions for state residents who contribute to the state's own plan. However, there is no federal regulation that prevents residents from contributing to plans in any other state that accepts nonresidents. In states without income taxes, residents should compare 529 plans around the country to get the best deal.
One disadvantage of 529 plans is the lack of flexibility. First, you are limited to the menu of funds available in any state's plan, which is a far narrower selection than you have for education-savings accounts. Second, you can change your existing 529 plan investments only once each calendar year (although you may change the investment selections for new contributions as often as you like). In an education-savings account, you can change your investments as often as the underlying mutual funds permit.
An additional problem with 529 plans is that their tax treatment is scheduled to worsen starting in 2011. Specifically, investment profits withdrawn to pay for college in 2010 or earlier are not subject to federal income tax . However, starting in 2011, profits are slated to become taxable at the most unfavorable, ordinary- income tax rates. Investment profits withdrawn, but not used for college, are subject to ordinary income tax plus a 10 percent penalty tax.
Under current tax regulations, education-savings accounts appear to offer the most investment flexibility, the best tax treatment, and the lowest potential costs. Your first course of action in saving for your children's college should be to contribute as much as you can to education-savings accounts.
Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or [email protected]. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.
