Your Money: Educate Your Kids without Going Broke

“Are you kidding me?”

I often get that reaction from physicians when I estimate how much it will cost to send their children to college. Physicians know that college is expensive, but few realize that when you consider income taxes and lost investment growth, the true cost of college is far more than even the astronomical tuition, room, and board that universities charge.

Let’s take the example of a recent physician client of mine; we’ll call him Dr. Walters. When I told him that his family’s expected annual contribution to his daughter’s college would be about $100,000 - almost three times the cost of the school’s tuition - he nearly hit the roof. He went to a colleague’s broker, who advised him to move assets in order to qualify for financial aid. “I looked into it but buying annuities and life insurance only seemed to make the broker rich,” Dr. Walters told me.

His daughter’s four years at college could reduce Dr. Walters’ retirement fund by more than $500,000. Most physicians are ineligible for financial aid; they are caught in a conundrum similar to Dr. Walters’.

The question: How can you fund college without jeopardizing your retirement plans or your current standard of living?

Many have saved for college, but not nearly enough. In fact, the College Board reports that the average 529 college savings account holds $10,569, less than the cost of one year at a typical public university.

To cope, consider the following strategies:

1) Insist on precollege planning for your kids. According to the sponsors of the ACT college admissions exam, only 51 percent of college students graduate within five years. Every extra year of college adds at least 20 percent to the family’s out-of-pocket college costs. One problem is that only about half of high school students receive any career or college planning. This lack of preparation is a primary contributor to college dropouts, transfers, and extensions. Precollege planning begins with assessing your kid’s interests, values, skills, and personality through a reliable and credible career-testing program. You can then match your kid’s interests to a college major. Only then should your child pick a college.

2) Give your kid a job. Compensating your child through your practice or another business you own is among the most powerful of college funding techniques. Your teen-ager could perform clerical tasks such as preparing patient statements, filing, and answering phones. Even a dependent child can take a standard deduction of $5,150 (for 2006) to offset against income earned through employment. This means your practice can pay up to $5,150 for legitimate work performed by the child, but the child will pay no federal income tax. If you do this before your kid starts college, the compensation technique becomes even more powerful. If the child’s wages exceed the $5,150, she can claim an IRA deduction of up to $4,000 (2007 limit). Much has been made about section 529 plans that provide tax-free growth when used for education. Since IRA withdrawals for college expenses are not subject to the normal 10 percent early withdrawal penalty, your child’s IRA can be even more powerful than a 529 savings plan, because IRA contributions are deductible for federal income taxes while 529 plan contributions are not.

3) Get a tax scholarship. Planning to liquidate assets to help you pay for college? Transfer them into your child’s name first, and realize a “tax scholarship” equal to the difference in capital gains tax rates that you and your kid will pay.

For example, if you plan to pay for college by selling a stock portfolio worth $60,000, which had an original cost of $20,000, you will pay capital gains taxes of $6,000 - 15 percent on the $40,000 gain. Your kid, however, would face a capital gains tax rate of only 5 percent, paying only $2,000, giving your family a $4,000 “tax scholarship.” A family receives a tax scholarship when funds that would have been used to pay taxes are instead used to pay education costs. A word of caution: Exercise care in shifting appreciated assets to children under age 18; investment income exceeding $1,700 is taxed at the parents’ rate, not the student’s rate.

4) Use section 127 plans to pay and deduct college costs. These plans allow your practice to pay up to $5,250 of college expenses per year, but do not require your kid to recognize the tuition payment as income. To properly use a section 127 plan, physicians must adhere to several rules: the student must be 21 years old; the student cannot be a tax dependent of the physician; the student must be an employee of the medical practice; and the plan cannot discriminate against employees not related to the physician.

5) Remove the student from your tax return. If you stop claiming your child as a dependent, he can utilize tax credits that would not be available to you because you make too much money. The Hope Credit provides a dollar-for-dollar tax credit of up to $1,650 for college tuition paid during each of a student’s first two years of college. The Lifetime Learning Credit provides a dollar-for-dollar tax credit equal to 20 percent of the amount of college tuition paid, up to a maximum of $2,000, regardless of when the tuition is paid.

Most physicians exceed the $110,000 income limit for using these credits. Fortunately, you can simply choose not to claim your college-age child as a tax dependent. Such children can claim themselves. Of course, not claiming the student will eliminate the $3,200 dependency deduction for you. However, you begin to lose the ability to claim this deduction anyway if you (or you and your spouse jointly) make at least $218,950. You lose the deduction entirely if your annual income exceeds $341,450.

A little careful planning can reduce the out-of-pocket expenses of your children’s college costs while helping maintain your standard of living and preserve your retirement fund.

J. Wayne Firebaugh, CPA, is the president of Wayne Firebaugh Inc., a registered investment advisory firm, and the author of “How to Survive the High Cost of College - 153 Strategies to Cut College Costs.” He can be reached at 540 366 5800 or via editor@physicianspractice.com.
This article originally appeared in the June 2007 issue of Physicians Practice.