Saving for College: The Ultimate Savings Machine for Physicians

Imagine that you're on a road trip with your teenager. You're driving down the highway, hopefully having one of those can-only-have-it-in-the-car heart talks, discovering who they really are, and working in some quality time. But as you're talking, you realize this is both the happiest and the saddest trip of your life: you're driving your kid to college. How will you get there?

It's time to wipe the tears out of your eyes and snap back to the present because we're going to test drive three different "vehicles" you can use to save for college.

1. The Uniform Transfer/Gift to Minors Account (UGMA/UTMA)

It all depends on which state you live in as to whether there's a "T" or a "G" in this one's name, but both the UTMA and the UGMA do basically the same thing, and that is to hold money for a minor child's benefit.

Up until the time your child reaches the "age of majority" (usually 18 or 21 depending on your state), you can use the money for just about any kind of education (college, private K-12, etc.) and other non-essential expenses (like violin lessons and space camp).

You see, the UTMA is not really a college savings vehicle at all. Rather, it's truly a "custodial" account for the benefit of a child. It solves the problem that crops up when a minor receives a gift or inheritance before they're old enough to be legally responsible for him/herself.

UGMA's have long been the de facto standard for college funding (and we still see old stockbrokers setting these up for none-the-wiser clients) but this tax break was greatly diluted by recent changes in the "kiddie tax" law (call your tax advisor for details).

What's bad about Uniform Transfer to Minors Accounts is that when your kid reaches the age of majority, the money is all theirs. I say "kid" here because your child may not actually be a student when they receive the money, and they may actually decide to take the money out and blow it! It's THEIR money and they can use it any way they like.

If college savings vehicles were cars, this one would be a lemon, and we mention it here only so you'll know not to pursue it.

2. The Coverdell Education Savings Account

Formerly known as the "Education IRA", the Coverdell Education Savings Account (or CESA) is a decent alternative for funding college for most people, but it's not that great for doctors who want their brighter children to attend better colleges.

Why?

The limit on contributions to these accounts is only $2,000 per year per child. By the calculations in our previous articles, that's less than 16% of the total savings you'd need to set aside to pay for the Ivy Leagues.

From a tax standpoint, CESA's function much like a Roth IRA. Contributions are made on an after-tax basis. Earnings grow tax-deferred, and qualified withdrawals are tax-free. Between now and the year 2011, you can use the money for qualified K-12 and college expenses. After 2010 CESA's are for college expenses only.

Where rights of ownership are concerned, beware that the CESA functions much like the UTMA. At some point, your kid can take possession of the money.

Bottom Line? If grandma and grandpa are reading Money magazine and they're bent on opening a CESA for your kid, take the money. Otherwise, make a move up to the BMW of college savings accounts...

3. The Ultimate Savings Machine: The 529 Plan

There are two things I love about the 529 plan accounts: asset protection, and asset protection.

First, asset protection. When you put money into a 529 college savings account, you're putting money into YOUR OWN account, not an account for your child. When you look at the statement, it will say, "Dr. William B. Killdare", not "William Killdare for the benefit of William Killdare Jr." That means you always have control of the money, and you can withdraw the money (with a small penalty) at any time should your child decide not to go to college.

"Pshaw." I can hear you say, "There's no way my child won't go to college." And I believe you. But if you read my last article, then you know you should start saving very early, and it's tough to know exactly how a 1-year old will turn out. If you want to be certain, then you can use the 529 to keep the money under thumb.

Now, let me tell you about the other kind asset protection. In some states, 529 college savings plans are regarded as "spendthrift trusts," meaning creditors can't get their hands on the money before the beneficiaries can use it for the designated purpose. Congress also saw fit to wrap these accounts with protection under the recently-enacted Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (what the pros call "BAPA"). This is not legal advice, so consult with your attorney before relying on these details.

Beyond the obvious benefit of protecting the money you'd use to pay for college, there are other perks.

  • There's practically no limit as to how much you can put into a 529 account, unlike CESA's.
  • Contributions in some states receive a tax break, earnings grow tax-deferred, and withdrawals are tax free when used to cover qualified higher education expenses (QHEE) like tuition, books, supplies, equipment and a certain amount of room and board.

 

The only caveat about 529 accounts is just this: If you put more money in the account than you can actually use, be prepared to pay taxes and penalties.

Bottom Line: For physician families, the 529 is generally the best vehicle for college.