The Physicians Guide to Saving for College
Saving for College
Saving for college is a monumental task. The savings aspect alone is enough to warrant questions, debates, and discussions with your family and financial advisor.
The questions are plentiful. How do you know how much to set aside? How much higher can the cost of college continue to climb? How do you know for sure your child will even attend college? These are all valid questions as you start to make real decisions for your child’s future.
And for physicians, the decision is just as difficult.
Sure, you will be making a great salary (if you aren’t already) and have a steady income. By the time your kids go off to college, you’ll presumably be well-established in your practice with a consistent, dependable salary to match.
But this doesn’t mean you want to “wing it” when it comes to saving for such a big milestone in your child’s life either. You’re wondering what you can do right now so you can be in the best position possible in 5, 10, or 15 years down the road.
How Much To Save for College Expenses
There are plenty of different calculators out there and tools out there to understand this question where you can go in and punch in numbers about how old your child is and what your aspirations are for what type of school they would go to and also how much of the college education you would like to aspire to fund.
Here are a few of the college savings calculators we like:
- CollegeBacker’s College Savings Calculator
- Savingforcollege.com’s College Savings Calculator
- Fidelity College Savings Calculator
Once you determine the amount you need to save to reach your goal, you’ll want to review your budget to see how much you can afford to save.
Some parents worry about over funding the account, luckily, there are some flexibilities built-in with a 529 plan already.
If your child gets a scholarship, you may be able to still withdraw the funds from the 529 plan. 529 plans are actually designed to be supportive of scholarships. If your child earns the scholarship, you can withdraw the amount of the scholarship without any penalties. You can go ahead and spend that money on another purpose.
Of course, there’s a lot more to college costs than just tuition. You can also use 529 funds on room and board, on books and even computers. Even if your child gets a full-tuition scholarship, you still might want to use that 529 money for something else.
But then the other question is, even with the scholarship rule, what if I just have extra money left over after my child has completed their four years of whatever school they went to? Am I stuck and what do I do with that? So first I would say, congratulations, you’re a great saver and so that’s a very good problem to have, but you still have options.
You can also use 529 funding on other forms of higher education. If your child is considering graduate school or something else, you can use that money for other forms of higher education.
You can also change the beneficiary on 529 plans. If you have a second child who is going to school, then you can transfer the 529 funds into the second child’s name. If you want to go back to graduate school or get some other education, you could even transfer it back to yourself and use that money on some form of higher education.
It is true that if you don’t use the money for anything that is higher education-related, then you will have to pay taxes on the gains and a 10% penalty on those non-qualified withdrawals. But remember, that like a Roth IRA, you can actually always withdraw the principal of that account without any taxes or penalties. So there is quite a bit of flexibility built into the 529.
Types of Accounts for College Savings
There are several ways to save for college, you can even technically use a general savings account. Here are the various places you can invest for college in a tax-advantaged way.
529 plans are a tax-advantaged investment account for college, you can think of it as a Roth IRA. You put in post-tax money and then the growth is completely tax-free and the withdrawals are tax-free as long as you’re using them for higher education.
California has its own 529 plan, New York has its own, Illinois has its own, every state has its own 529 option. There are a ton of different options out there, however, even though each state has its own 529 plan, you don’t necessarily have to choose your own state’s plan.
This means that you have a lot of different options, of course, some states do want you to use their in-state plan and so they may offer an incentive for you to be saving for college and that incentive usually comes in the form of a tax deduction.
So for example, if you are an Illinois resident and I use the Illinois 529, then I can take an income tax deduction on my state income tax for any contributions made to that plan. But it varies state by state, so this can get pretty confusing. Our recommendation is to first, check out whether your state has an income tax deduction. If they don’t, then it means that you can choose any plan and you should basically just go out there and figure out what the best plan for you is.
If they do have a state income tax deduction, then ask whether that income tax deduction is only for your state plan or for any state plan. So for example, if you’re a resident of Pennsylvania, there is a state income tax deduction, but you can take that deduction on contributions to any state plan. So if you live in Pennsylvania, you could be using the California,Texas, or Utah 529 and still take that income tax deduction.
CollegeBacker is the most popular private 529 plan on the market today. The best feature of CollegeBacker is how easy they make it to invite others to make a gift to the account. When it’s time for gifts, I have told my family to make a small contribution to the account instead of getting them toys that they will break or stop using within a few months.
The crazy part CollegeBacker is that they really do want to stick to their mission of helping all families save for college. The way that they set up their fees and structures is represented in that. It’s a donation-based payment system, so you pay what it’s worth. That’s right. You literally could pay them nothing, or if inclined you can give anywhere between $0 and $10 a month.
In the world of 529 plans, there is a wide range of expense ratios. The best-in-class out there typically are charging around 0.2% on the assets, whereas some of the more expensive plans can easily be over 1%. The typical advisor sold plan is around 1.3%.
Having a high expense ratio could have significant impacts on the amount that is in the account when it’s time to pay for college. A 1% difference in fees might not seem like much, but 1% on $30,000 is $300. That’s enough to pay for a textbook, just one textbook though.
Here are some other benefits of a 529 plan:
- Federal Tax Breaks – Your money grows tax-free and you are not taxed when it’s taken out if used for college
- State Tax Benefits – Over 30 states offer residents a tax deduction for contributing
- You Have Control – The funds are yours for the entire life of the account. (The beneficiary has no legal right to the money in the 529 plan.)
- Low Maintenance & Quick and Easy to Set Up
- High Contribution Limits – Assuming you’re married, your family can contribute up to $28,000 per year per child without any tax consequence.
- Automatic Investment Options
- Professional Money Management – If you have a financial advisor.
- Simple Tax Reporting – There is nothing to report on your taxes until you make a withdrawal.
- You Can Change Your Investment Options Twice a Year
- Everyone is Eligible – There are no restrictions with regard to income, employment, or age.
Formally called the Education IRA, the Coverdell Education Savings Accounts is another way to save for college. Just like a 529 plan, Coverdell accounts offer tax-free investment growth and tax-free withdrawals for qualified education expenses.
Coverdells can be used for K-12 education including books, supplies, equipment, academic tutoring, and special needs services.
If you are primarily saving for college and not for K-12 private school, then a Coverdell might be too limited for you. A 529 plan, in contrast, is going to have a lot more flexibility and it’s going to not have those income limits and contribution limits.
UGMA (Uniform Gift to Minor Act)
The Uniform Gifts to Minors Act essentially is a trust account or a custodial account that you can set up for your child that is not necessarily focused on education. You’re basically just putting together a group of assets that you’re gifting to your child.
There are some significant drawbacks to this though, because that gift is going to automatically be transferred to your child’s control upon age 18 or 21, and that means that the child is going to have full control of those assets. They might spend it on education or they might spend it on something else.
It’s also going to have some negative financial aid consequences, compared to other accounts used for college. For financial aid purposes, assets in a UGMA are going to be considered student assets and that’s going to have a really significant impact on financial aid.
Using a Roth IRA for College Expenses
While you can use a Roth IRA for college expenses, it’s one of the least tax efficient ways to accomplish this goal. Whatever you contribute to a Roth IRA can be withdrawn tax-free, because you already paid taxes on it, the earnings are taxable and could incur an additional 10% fee for early withdrawals.
Not only is a Roth IRA not tax efficient when used for saving for college, but you’re limited on how much you can save in it each year by the annual contribution limits and income thresholds. You can, however, convert a pre-tax or traditional retirement account into a Roth IRA through a Roth conversion to save more into a Roth over the annual limitations. By doing this however, you could pay heavy taxes on the growth in your account and be further limited by the 5-year rule. The 5-year rule stipulates that you must wait 5 years to withdraw the earnings that were converted from a traditional account to the roth. There are situations where the 5-year would not apply, such as if you are older than 59 ½.
Using Life Insurance for College Expenses
As a financial advisor, I’m asked a great deal about the right way to save for college. A common question is whether to tap into a whole life insurance policy or set aside funds for a 529 college savings plan.
We want to consider the pros and cons of using whole life insurance versus a 529 college savings plan for future education. Let’s see how these two options compare to one another.
If you have already chosen a whole life insurance plan, then you need to know your options available with your policy. Tapping into a whole life insurance policy could be a consideration if the policy has been in place for several years.
But be warned. If you choose to use the cash value of your policy to help fund a college education, you need to make sure you understand the fees associated with withdrawal. There could also be a potential tax penalty if you withdraw from your policy prior to age 59 ½.
Borrow Against the Death Benefit
There is a way you can borrow against your death benefit with your whole life insurance policy, in order to fund college. Your whole life policy may have built up a cash benefit, depending on how many years you’ve had the policy.
By using the money against the death benefit, you can either choose to pay it back or your agent can simply deduct what you need to withdraw from the payout upon death.
Policy Is Not Factored in Earnings
If your child is applying for financial aid, whether it’s in the form of a scholarship or student loans, then a whole life policy will not be used to calculate parental assets. This is where the 529 differs because a 529 will be taken into consideration with the applications.
Will Not Incur the Penalty If Child Doesn’t Attend a Post-Secondary School
As mentioned earlier, with a 529 plan, you will be subject to a penalty if the funds end up not being used and you choose to withdraw them for non-educational purposes. Obviously, if your plan is to use your whole life policy and you end up not using it, then you don’t have to worry about incurring a penalty.
But giving advice on how you can use whole life insurance to help finance education shouldn’t be perceived as an endorsement for obtaining whole life insurance. As a fee-only financial advisor, we always advise our clients to consider a term-life policy instead of whole life insurance. However, it’s likely some of you already have a whole life policy in place and you are wondering what your options are for post-secondary education.
Time is on your side when it comes to saving for college, so it’s important to get started as soon as you can. Even a $25 a month contribution can turn into $10,000 by the time an infant reaches college age.
Where to save for college will depend on your goals and your unique situation, however, there are rarely times where a 529 plan isn’t the best option.