When and How To Save, Invest, and Pay for College
College costs rose 6.6% in 2007, or about twice the inflation rate.
by John K. McGill, MBA, CPA, JD
For more on this topic, go to www.dentaleconomics.com and search using the following key words: college, college costs, tuition, student loans, college savings plans, education costs.
College costs rose 6.6% in 2007, or about twice the inflation rate. Average tuition and fees are now $6,185 at public colleges and universities, and $23,712 for private colleges. Meanwhile, tighter government restrictions and the current credit crunch are reducing the availability of student loans. As a result, the portion of college costs being borne by doctors' families is increasing annually.
When to start?
These factors have caused most stockbrokers and financial planners to recommend that doctors begin saving for college shortly after a child's birth, primarily using Section 529 college savings plans. While that's usually the best approach for many wage earners, it can prove extremely costly for doctors and other self-employed business owners.
We recommend that doctors do not begin saving for their child's education costs until age 6. Before that, doctors should save for their retirement as a first priority. Most doctors' savings for retirement have not increased since 1999, despite anemic investment returns. In fact, many doctors are now saving less for retirement due to stagnant or lower practice net incomes. Accordingly, more and more doctors are falling behind in saving the amounts necessary to assure financial security in retirement.
How much to contribute?
Meanwhile, a philosophical debate rages over whether it's your duty as a parent to pay all college costs for your children. Or, will your child take college and professional school more seriously if he or she has some money in the game? Furthermore, will your child be better or worse equipped to handle finances if he or she owes student loans after graduation? And, will children appreciate their education much more knowing that they are paying for it with their own money through a combination of scholarships, loans, and work?
The reality is that many high-income doctors routinely overlook thousands of dollars in annual loans, grants, and scholarships that their child may qualify for to attend college, particularly private colleges and universities. Working part time (less than 20 hours a week) during college is also an option to help "pay the freight," and build the child's work ethic and level of responsibility.
How to contribute (after-tax or tax-deductible funds?)
The goals in funding the portion of college costs that the doctor elects to pay are threefold. First, all education costs should be paid for with pretax (tax-deductible) dollars. In addition, the funds should be invested in accounts where they can grow tax-deferred. Finally, the funds should be paid out for education free of federal or state income taxes or penalties.
How do we achieve these optimal results? First, the Tax Court has approved tax-deductible funding of college costs through employing children as young as age 7 in their parent's business (See Eller vs. Commissioner, 77 T.C. 934 (1982)). Children can earn up to $5,450 free of federal (and in most cases state) income taxes in 2008. Moreover, this qualifies the child for the maximum contribution to a Roth IRA, as described below.
Furthermore, the employment of the child can usually continue while in college, graduate, or professional school. Children may serve as a corporate officer and director, and can provide valuable practice marketing, Web site development, Internet marketing, practice brochure design, and in some cases legal and accounting functions in the doctor's practice, even while in school. Moreover, those in dental school or specialty training can provide an even higher level of services, justifying a much larger salary.
Paying a higher corporate salary to equal or exceed 50% of the child's support while in college can pay tremendous dividends. As such, the child's earnings continue to be taxed at the child's lower (10% and 15%) tax rates. Moreover, in this situation, any unearned income of the child (interest, dividends, capital gains, rents, etc.) continue to be taxed at the child's income tax rate.
Single children with income below $32,000 can also qualify for a zero tax rate on capital gains and dividends in 2008 through 2010. Finally, taxes on the child's earned and unearned income can be offset through the use of the Hope and Lifetime Learning Tax Credits. In many cases, children earning $20,000 to $30,000 annually can end up paying zero in federal income taxes through playing their tax cards correctly, even under the new law.
Where to invest funds for college?
Typically, brokers and financial planners recommend investing all of the child's savings for college in a Section 529 college savings plan. While these plans have improved substantially in recent years, they are actually the third best option for doctors to achieve their goals. While 529 plans have high contribution limits and do offer tax-deferral, they provide the doctor with no control over the investment selection within the plan. Worse yet, funds remaining in the child's account are subject to federal and state income taxes and penalties if not used by the child, another family member, or relative for education purposes.
Our recommendation — invest the funds generated from the child's employment into a Roth IRA for the benefit of the child. While contributions are nondeductible, the earnings grow tax-free. Further, contributions made can be later distributed from the Roth IRA without taxes or penalty to pay for qualified educational expenses. More importantly, funds held within a Roth IRA that are not needed for educational expenses can continue to grow and accumulate tax-deferred, and can be withdrawn later by the child tax-free beginning at age 59½.
Any additional funds available should be invested in a Coverdell Savings Account. Nondeductible contributions of up to $2,000 annually are allowed to these accounts. In addition, all funds invested grow tax-deferred within the account, and can be distributed tax-free for educational expenses.
Like Section 529 plans, funds remaining in the child's account at age 30 are subject to federal and state income taxes and penalties if not used for educational purposes.
Any additional funds available for college savings should be invested in Section 529 plans. Several years ago we published an article titled, "Section 529 Plans: Where's the Beef?" advising doctors that there were much better ways to save and invest for college than through utilizing these highly touted accounts.
Since that time, state income tax breaks expanded, investment options improved, and costs have been reduced, making Section 529 plans a better deal. Yet, they are still the third best option for most doctors.
Most states sponsor at least two Section 529 college savings plans, so selecting among them can prove difficult. Doctors can compare the Section 529 college savings plans at www.collegesavings.org and www.savingforcollege.com.
More importantly, Morningstar provides an independent third-party analysis of Section 529 investments.
According to their research, the top five performing Section 529 plans are offered by Colorado, Maryland, Nebraska, Utah, and Virginia. For more information, go to www.morningstar.com, click "Personal Finance," then click "Section 529 Plans."
Doctors purchasing Section 529 college savings plans should generally invest in their own state's plan (if investment performance is adequate) to remain eligible for a state income tax deduction now offered by 31 states and the District of Columbia.
In addition, doctors should buy 529 savings plans directly, not through brokers. While 80% of savings plans are sold by brokers, buying direct avoids the 4% to 5% sales charges typically imposed on broker-sold funds.
Paying for college
Deciding which accounts to tap for college costs, and in what order, is critically important. Tapping funds in the wrong account first can jeopardize the doctor's ability to claim valuable college tax credits, and can result in penalties and loss of control over funds.
Funds within a child's custodial account, or his/her checking or savings account, should be tapped first to meet college expenses. This minimizes or eliminates loss of control over these funds when the child reaches majority (age 18 in most states).
Moreover, funds withdrawn from custodial accounts and checking and savings accounts and used for college costs can qualify children for the Hope and Lifetime Learning Education Tax Credits on their return.
Funds within Section 529 college savings plans should be tapped next. Doctors should avoid overfunding these plans since any remaining balances after college costs are paid are subject to federal and state income taxes and penalties. Since doctors lack investment control over these accounts, it makes sense to deplete these funds next.
The third source of funds to tap for paying college bills are those in Coverdell Savings Accounts. While the doctor retains investment control over these funds, nevertheless, amounts remaining in the fund when the child reaches age 30 are subject to federal and state income taxes and penalties, if not used for educational expenses.
The final accounts to tap to meet college costs are Roth IRAs. Here the doctor retains full control over the investments within these accounts. More importantly, funds not required for educational purposes can continue to grow tax-deferred, and can be paid out tax-free after age 59½.
This article was reprinted with permission from The McGill Advisory, a monthly newsletter devoted to tax, financial planning, investment, and practice management matters exclusively for the dental profession, available for $217 a year from John K. McGill & Company, Inc., Lake View Professional Building, 8816 Red Oak Boulevard, Suite 240, Charlotte, NC 28217; or call (888) 249-7537 for further information.
John K. McGill, MBA, CPA, JD, is a tax attorney, CPA, and MBA, and the editor of "The McGill Advisory," a monthly newsletter devoted to tax, financial planning, investment, and practice-management matters exclusively for the dental profession. The newsletter ($217 a year) and consulting information are available from John K. McGill & Company, Lake View Professional Building, 8816 Red Oak Blvd., Ste. 240, Charlotte, NC 28217. Call (704) 424-9780, toll-free (888) 249-7537, or visit the company's Web site at www.bmhgroup.com.