College savings plans help save money for students’ higher education
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Many Americans would agree money spent on higher education is one of the best investments. No other asset class has the ability to change the trajectory of a young person’s life as powerfully as a college and graduate education. For this reason, many parents and grandparents strive to empower young students to pursue their dreams through higher education.
Unfortunately, for many, college and graduate education has become too expensive to consider. Based on figures from College Board for 2019 through 2020, the average tuition and fees for a private college are $36,880 annually and for an in-state public university are $10,440 annually. In other words, the 4-year cost of a private college is likely to exceed $147,000, if inflation was unrealistically removed from the equation. These figures do not include room and board, books and supplies, and many other typical expenses college students incur.
At many colleges, the tuition increases have outpaced the inflation rate, a statistic that all but ensures higher education may be out of reach for many American children today. Student loans are available, but if managed improperly, they can saddle a young adult with insurmountable debt during their prime earning years.
Wouldn’t it be great if you could give your child or grandchild a “scholarship” to help him or her achieve their higher education goals? In this column, we explain how a college savings plan can leverage the power of time and compounding interest when saving money for higher education.
Know your options
There are several tax advantaged plans to consider when preparing to set aside money for higher education. We will discuss the differences between 529 savings plans, 529 prepaid tuition plans and Coverdell plans, previously known as education individual retirement accounts or IRAs. There are several key features to keep in mind when determining which investment plan is right for you and your family. These include income limitations, maximum yearly contribution limits, tax status of earnings and contributions, owner of account, and investment options within each plan. The table summarizes the college savings plans discussed in this article.
529 college savings plan
A 529 plan is a flexible savings account operated by a specific state or educational institution that is designed to encourage and help families save for future college, as well as K-12 education costs.
Named for a section of the tax code that specifies its parameters for use, 529 plans offer some federal and often some state tax advantages. Fortunately, for physicians, the plans are also set up to minimize the impact of the additional funds on potential financial aid. 529 plans come in two general categories: savings plans and prepaid plans. A 529 savings plan functions like a 401(k) with plan contributions invested in state-run allocation programs that include mutual funds or similar investments, typically with a variable risk profile that can be selected. Prepaid plans, on the other hand, permit prepayment of all or part of the costs of a specific in-state public college. These plans can be converted for use at private and out-of-state colleges.
You can withdraw money tax-free from a 529 plan, provided the funds are used to pay for qualified education expenses, including tuition and costs to attend any K-12 school, college, university or other eligible institution. Specific restrictions and rules apply to whether expenses related to room and board, textbooks and technology can be considered qualified expenses. You may be subject to penalties and/or tax on 529 withdrawals used for non-qualified expenses.
To set up a 529 plan, you can go directly to the fund plan manager or work with an advisor to select the plan best for your needs. Almost every state has a 529 plan available, however specifics of each plan vary by state. Overall, the 529 savings plan has numerous advantages and allows the greatest amount of college savings dollars to be contributed per year in tax advantaged investment vehicles.
Coverdell education savings account
Another college savings option with which physicians may be less familiar is the Coverdell education savings account, an education investment account established through eligible brokers. Previously known as an education IRA, Coverdell plans differ from 529 plans in that only $2,000 per year (post-tax) may be contributed to a single child’s plan. However, all returns thereafter are tax-free when used for qualified educational expenses. Additionally, the plan allows for investment in any individual stock, bond, exchange traded fund (ETF) or mutual fund, while 529 plan investment choices are limited to state-run investment programs, as previously discussed. Functioning like a Roth IRA for education, the flexibility of a Coverdell savings account can be a benefit to physicians who are self-directed investors and wish to manage their portfolios with diversified stock and ETF holdings.
Most physicians are discouraged by the Coverdell’s income limit for donors to an adjusted gross income annual of $95,000 to $110,000 for single filers and $190,000 to $220,000 for joint filers. It should be noted that any child can have a Coverdell education savings account in their name. Physicians who make more than the allowable income can gift the $2,000 contribution to their child, who presumably has no income, and the child can then contribute to their own Coverdell. Unlike Roth and Traditional IRAs, there is no requirement that the contributor have earned traditional income.
Although $2,000 per year seems like a nominal amount compared with the cost of higher education, the power of compounding can make regular contributions balloon to significant value. For example, consider someone who established a Coverdell education savings account when his or her child was born and contributed $2,000 each year. Assuming a conservative 7% rate of return on an index stock ETF, the amount of tax-free money available for qualified expenses would compound to $72,758 by the child’s 18th birthday, which is more than double what was invested.
Conclusion
Although there has been some political discussion about initiatives to reduce the cost of higher education, most of these proposals would not be applicable to children of physicians and other higher income households. Fortunately, with careful planning and an early start on saving, one or both of these tax-efficient college savings options may allow physicians to harness the incredible power of a compounding asset class to help their children or grandchildren achieve their higher education dreams.
- References:
- https://research.collegeboard.org/pdf/trends-college-pricing-2019-full-report.pdf
- www.savingforcollege.com/intro_to_esas/?esa_faq_category_id=2
- Wealth Protection Planning for Orthopaedic Surgeons and Wealth Management Made Simple are available free in print or by e-book download by texting OT20 to 555-888 or at www.ojmbookstore.com. Enter code OT20 at checkout.
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Illinois. He can be reached at email: sanjeevbhatia1@gmail.com.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at mandell@ojmgroup.com or 877-656-4362.
Disclosures: Bhatia and Mandell report no relevant financial disclosures.
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