Physician Finances

Paying For Your Child’s College Education

Raising a kid is expensive. And it all culminates with the cost of a college education. One of the most gratifying things about being a parent is seeing your child be successful and one of the best ways to ensure that success is a strong education. Thus, one of the most important gifts we can give our children is a college education. But that education is expensive and gets even more expensive every year.

Summary Points:

  • College costs rise faster than inflation.
  • To pay for a child’s college education, it is important to start saving as early as possible.
  • Saving options include (1) uniform gifts to minors accounts, (2) Coverdell education savings accounts, (3) Taxable brokerage accounts, (4) Roth IRAs, (5) 529 plans, and (6) loans.
  • The best option depends on the parents’ unique individual financial situation and the likelihood that at least one child will attend college.

The U.S. Bureau of Labor Statistics reports that for the 40 years between 1980 and 2020, the consumer price index rose by an average rate of 3.54% every year. The College Board tracks trends in college pricing and notes that the average annual increase in tuition and fees at four-year public institutions between 1980 and 2020 was 3.4% above inflation. For private nonprofit four-year institutions, the average annual increase over the same period was 2.6% above inflation. Taken together, these statistics indicate that the cost of college education has increased 7% per year for public colleges and 6% per year for private colleges over the past 40 years. The good news is that for the past year, college costs have risen less than the rate of inflation: between February 2023 and February 2024, college tuition and fees increased by 1.3% whereas the consumer price index increased by 3.2%. However, it is not clear whether this lower increase in the cost of college is sustainable – given the reductions in state government support for public higher education and the declining enrollment in U.S. colleges, it is more likely that college education inflation will return to its historic annual rates of 6-7% in future years.

The cost of college 18 years from now

The cost to attend college includes tuition, fees, books, room, and board. The price of tuition varies considerably, depending on whether a student attends an in-state public university or a private university. As an example, I have children that attended the University of Notre Dame (private), the Ohio State University (in-state public), and the University of Dayton (private). For this analysis, let’s assume an average annual inflation rate of 5% for the total cost of college with the assumption that tuition and fees will increase about 6-7% per year but room and board will be closer to the consumer price index average of 3% per year. For a freshman entering this year, the Ohio State University currently costs $27,241 for the first year and $108,964 for four years. The University of Dayton currently costs $63,240 for the first year and $252,960 for four years. The University of Notre Dame currently costs $80,071 for the first year and $320,284 for four years. But with an annual increase of 5%, in 18 years, those costs will rise to $282,566 (Ohio State), $655,978 (Dayton), and $830,562 (Notre Dame). If I was starting my family today, it would cost me more than $2.4 million to put my four kids through college.

You can’t count on financial aid

The most recent data from the U.S. Department of Education’s National Center for Education Statistics showed that 72% of undergraduate students receive some form of financial aid. 55% received federal aid, 23% received state aid, and 28% received institutional aid. The most common type of aid received were grants and scholarships (64%) followed by student loans that the students took out themselves (36%), work-study (5%), federal direct plus loans that parents took out (4%), and veterans education benefits (2%). The average total annual financial aid package was $14,100.

Because much of financial aid is based on income, children of physicians (and other well-compensated professionals) are usually only eligible for athletic or academic scholarships. As a result, if you are a physician, attorney, dentist, or business executive, your dependent children will not be eligible for most forms of financial aid because your income is too high. Because a college education is projected to be so expensive, you need to start saving for your child’s education starting on the day that child is born.

A colleague of mine in academic medicine had not given a lot of thought about saving for college until his children were in high school. When the first tuition bills came due, he did not have enough saved up and so he took out a second mortgage on his house to pay for his kid’s college education. He ended up postponing his retirement by several years in order to pay back the money he had to borrow. The lesson is that you cannot start saving for college too early but you can start too late.

Six ways to save for a child’s college education

There are several different ways to save for college and each has advantages and disadvantages. In my opinion, 529 college savings plans are the best way to go for most people but I will review other options as well.

(1) Uniform Gifts to Minors.

This program was created in 1956 by the Uniform Gifts to Minors Act. A very similar program in some states is the Uniform Transfers to Minors. It allows parents to give their children financial assets. The parent (or some other designated adult) is appointed as the custodian and controls those assets until the child reaches the age of majority. The age of majority varies by state but in most states is between 18 and 21-years-old. The money in the account can be used for any purpose. Additionally, these gifts are irrevocable, meaning that the parent cannot take the money back to use for some purpose other than support of the child. Any unearned income from the investments can be reported on the parent’s federal income tax returns as “kiddie tax” meaning that the first $1,250 of unearned income is not taxed, the next $1,250 is taxed at the child’s income tax rate, and anything over $2,500 is taxed at the parent’s income tax rate. There is no limit to the amount that a parent can put into a uniform gifts to minors account but contributions greater than $18,000 per year are subject to federal gift tax laws.

The biggest disadvantage of uniform gifts to minors (or the similar uniform transfers to minors) is that because the account is the property of the child, that child can use the money for whatever he or she wants after reaching the age of majority. If the age of majority is 18-years old in your state, then when the child turns 18, that child can use the money to buy a Corvette instead of using it for college and there is not a thing you can do about it. This happened to a friend of mine who regularly saved for his son’s college education by contributing to a uniform gifts to minors account. His son ended up getting a scholarship and then when he turned 21 (the age of majority in his state), he had $75,000 in spending money that he used to travel around the world. The father would have liked to use that money to pay off the mortgage on the family home but there was nothing that he could do about it.

The main advantage of the uniform gifts to minors accounts is that they can be used for anything for the child and not just the child’s education. Because the first $1,250 of annual unearned income (interest, dividends, and capital gains) are not taxed, this can be a great way to save up for expenses such as summer camp, skiing lessons, or a car for the child before that child reaches the age of majority for your state. But as a way to save for college, there are better options.

(2) Coverdell education savings accounts.

These are accounts that can be opened for a child under age 18 to pay for educational expenses. The money in the account grows tax-free and withdrawals are not taxed as long as they are used for educational purposes. Unlike the uniform gifts to minors accounts, any residual funds that the child does not use for his or her education can be transferred to another family member’s account. They are limited to parents with incomes of less than $220,000 (married filing jointly). The maximum contribution is only $2,000 per child per year. Because of the parental income limit, these accounts are generally not an option for most physicians or other well-compensated professionals.

(3) Taxable brokerage accounts.

If you (the parent) want to have the greatest flexibility for how the money you are saving can be used, then open a brokerage account in your name and contribute to it regularly with the intention of using the money in that account to pay for your child’s education. The account is in your name (just like any other investment account you have) so if your child does not need the money for a college education, then you can use it for your own purposes since it is your money.

The disadvantage of a taxable brokerage account is the taxes. You will pay capital gains tax when you sell the investments and you will pay regular income tax on annual unearned income (interest and non-qualified dividends) from the investments. Money used to pay for the child’s college education can also be subject to the gift tax limits which is $18,000 per child per year in 2024. There are ways around that limit, however. Money that you as a parent spend for tuition is not included in the gift tax limit as long as you pay the college directly from your own accounts (and not give the money to the child for him or her to write a tuition check from his or her account). Also, the gift tax limit is $18,000 per parent so if you are married, you and your spouse can each give the child $18,000 each year ($36,000 total) to cover their non-tuition living expenses.

(4) Roth IRAs.

Most people are familiar with using a Roth IRA to save for their own retirement. You take money that you have already paid income tax on and put it into a Roth account and then when you are retired, you can take money out of the Roth account tax-free. If you take money out of the Roth IRA before age 59 1/2, then you have to pay a penalty to the IRS. However, you can take money out of your Roth IRA before age 59 1/2 if you use it for educational expenses for yourself, your spouse, your children, or your grandchildren. The IRS will likely look at those early withdrawals so it is important to maintain careful records documenting your child’s enrollment in college and receipts for tuition, fees, books, and room and board. The nice thing about this college savings strategy is that any money that you don’t use for the child’s education can just remain in the Roth account for you to use in your own retirement.

There are some notable restrictions to Roth IRAs, however. You can only contribute directly to a Roth if your income is less than $240,000 (married filing jointly) and you can only directly contribute a maximum of $7,000 per year ($8,000 if you are over age 50). You can get around the income limit by doing a “backdoor Roth IRA”, meaning that you contribute first to a traditional IRA and then immediately convert the money in that traditional IRA into a Roth IRA. The maximum contribution to a traditional IRA is also $7,000 per year. Another noteworthy feature of Roth IRAs is that the penalty for early withdrawal before age 59 1/2 only applies to earnings from the money in the Roth IRA and not on the initial contributions. In other words, you can always take out an amount equal to the amount that you originally contributed to the Roth IRA anytime, for any purpose, without penalty. Note, however, that if you take more money than your initial contributions out of your Roth IRA to pay for your child’s college expenses, you will have to pay regular income tax on the amount of earnings withdrawals – you just don’t have to pay the additional 10% penalty. Withdrawals of earnings from a Roth IRA are also subject to the 5-year rule: the first contributions to the Roth IRA must have been at least 5 years prior to the earnings withdrawal to avoid a penalty (even if the withdrawals are used for educational expenses).

Because Roth IRA earnings are taxed when withdrawn before age 59 1/2 (even for educational purposes), the best way to use a Roth IRA for your child’s college education is to limit the amount of withdrawals to the amount that you initially contributed to the Roth account. As an example, say you put $8,000 into a Roth IRA this year when your child is born and 18 years from now, that Roth IRA is worth $32,000 ($8,000 initial contribution plus $24,000 earnings from interest, dividends, and capital gains). You can take $8,000 out of your Roth IRA for your child’s college expenses without penalty and without paying tax on it, leaving you with $24,000 in the Roth IRA that you can keep there to eventually withdraw tax-free in your retirement. If you were to take the full $32,000 our of your Roth IRA for your child’s college expenses, you would have to pay regular income tax on $24,000 (the earnings portion), but you would not have to pay the additional 10% penalty since it is for a qualified education expense.

(5) 529 plans.

These are accounts that are in the child’s name but that the parent controls. The investment grows tax-free and when withdrawals are used for educational expenses, the withdrawals are not taxed. Each state has its own 529 plan with its own investment options. Also, each state has different tax rules regarding 529 contributions. For example, here in Ohio, we can deduct the first $4,000 of contributions to each child’s Ohio 529 account, each year from our Ohio state income taxes. In 14 states, contributions are not tax-deductible from state income taxes. It is important to familiarize yourself with the tax rules unique to your particular state of residence.

Because the parent controls withdrawals and because those withdrawals can only be used for educational expenses, there is no risk that a child can take the money out to buy a Corvette on their 18th birthday. In addition, if there is money left over after one child finishes college, you can roll the residual funds over into another child’s 529 account. Or roll those funds into a 529 account for a grandchild. Or if you want to go back to school to get a Master’s degree, roll the funds into a 529 account for yourself. Living in Ohio, the tax advantages and the flexibility of the 529 plans make them unbeatable as a tool to save for college.

However, like any investment, you have to critically study exactly what it is you are investing in. Because each state’s 529 plan has different investment options, some states offer investments into mutual funds that charge relatively high expenses or that underperform compared to other mutual funds. As an example, when I first started contributing to 529 plans, Ohio only offered a group of managed mutual funds with high expense ratios and that had fairly low rates of return. Instead of contributing to Ohio’s 529 plan, I opened an account in Iowa’s 529 plan because they offered low-cost Vanguard index mutual funds. At the time, I had never even stepped foot in the state of Iowa. Once Ohio’s 529 plan changed to low-cost index funds, I transferred the money from Iowa’s 529 plan into Ohio’s 529 plan in order to reap the benefits of the tax deduction on contributions on my Ohio state income tax return.

The only disadvantage to 529 plans is that if you withdraw the money for something other than educational expenses, you get penalized. These penalties include paying federal and state income tax on the earnings withdrawals, a 10% federal penalty, and state-specific penalties. Nevertheless, even if you don’t use all of the money in your child’s 529 plan for their education and you don’t have any other family members with 529 plans to roll the residual funds into, you can still take the withdrawals and pay the penalties. This at least leaves you with something, unlike the uniform gifts to minors accounts where all of the withdrawals go to your child to spend anyway they want. Also, there are some exemptions to the 10% penalty, for example, if your child attends a U.S. military academy, gets a tax-free scholarship, or dies.

(6) Loans.

This is the least desirable option to pay for college. These can take the form of a government student loan taken out by the parents (such as federal direct plus loans), a loan taken out from a commercial lending company such as a bank, or re-financing the mortgage on a house. The interest that you will pay on these loans is expensive, especially now with mortgage interest rates are in the 6-7% per year range. A significant problem with student loans taken out by the parents is that those parents are generally in their 40’s our 50’s and the payments on these loans represent money that the parents could have been investing for their retirement. As a result, the parents will either have to retire at an older age than they had planned or have to live on a smaller annual income in retirement than they had planned.

Education loans taken out by the child are a bit different. Attending college is an educational investment in one’s career, allowing that person to have a broader range of job opportunities and allowing that person to have a higher income from those jobs than if they did not attend college. Thus, the loan is paid off by the child’s future working income rather than the parent’s future retirement income. Furthermore, if the child takes out federal direct student loans and then after college gets a job in a government organization or a non-profit company, then the principal on the loan can be forgiven after 10 years of working through the federal Public Service Loan Forgiveness program. Therefore, loans taken out by the child are not as bad of an option as education loans taken out by the parents for that child. Whether or not to the child should resort to taking out education loans depends on the parent’s financial ability to save for the child’s college education over 18 or 20 years and how much the parents prioritize education.

So, how much do you need to save?

If we go with the assumption that college education expenses continue to increase at 5% per year, then you should plan on your child’s college education account having at least enough to cover 4 years at a state-supported public college in 18 years for a child born today. Using the Ohio State University as an example, this means that you will need to have $282,000 in that child’s account in 18 years. There are several ways to get to this amount. The key is to take advantage of compound interest, meaning that the earlier you start, the easier it is to end up with $282,000 in the account. Ideally, you should put in an initial contribution at birth and then contribute a smaller amount every month for the next 18 years. Here are three options, assuming an 8% average annual rate of return on the account’s investments:

  1. Initial contribution of $20,000 plus $417 per month for 18 years.
  2. Initial contribution of $10,000 plus $500 per month for 18 years.
  3. Initial contribution of $0 plus $583 per month for 18 years.

If your goal is to send your child to a private college such as the University of Notre Dame, then plan on saving even more. You will need to have an initial contribution of $25,000 plus $1,500 per month for 18 years!

My recommendations

There is no single best solution for every parent. The more likely that a child will attend and complete college, the more important it is that the parents start saving early for that child’s college education. If one parent graduated from college, then the chances of a child going to college increases. If both parents attended college, then those chances increase even more. The more children you have, the more likely it is that at least once of them will attend college.

High chance at least one child will go to college. In this situation, the 529 plans just cannot be beat, especially if you live in a state like Ohio that overs a large tax deduction from state income taxes on annual 529 contributions. If the oldest child does not go to college (or gets a full scholarship to college), you can roll the money from that 529 account into another child’s 529 account. In the worst-case scenario and none of your children go to college you can withdraw the funds from their 529 plans for your own use – you will have to pay income tax and a 10% penalty on the earnings (but not the amount of your original contributions). Thus, you will still have made money off of the investments in the 529 plan, just not as much as if you had put the money directly into a taxable brokerage account in your own name. We had 529 plans for each of our four children and when each one graduated from college, we rolled the residual balance in their 529 account into the other children’s 529 accounts. Now that we have grandchildren (all out of state), we have opened accounts for each of them in Ohio’s 529 plan.

Low chance that your only child will go to college. If you only have one child and you are uncertain whether that child will attend college, you may want to put money in a Roth IRA instead of a 529 plan. Then, if a child does end up attending college or vocational school, you can withdraw the amount of your original Roth IRA contributions without penalty to pay for their education. You will still have all of the earnings that you made off of those contributions remaining in the Roth IRA for you to use in your retirement. If your child does not end up attending college, then just leave the money in the Roth IRA for you to take out tax-free in retirement. If both you and your spouse contribute the maximum to a Roth IRA (currently $7,000 per year per person), then in 18 years, there will be a total of $252,000 of contributions in your Roth IRAs, nearly enough to pay for 4 years of public university education 18 years from now. However, you should only use this strategy if you have additional other ways of saving for retirement, such as a 401(k), 403(b), 457, SEP IRA, etc. Otherwise, the total amount that you have saved for retirement will fall short.

Low chance that your multiple children will attend college. If you have more than one child and you are not sure if any of them are going to attend college but want to be prepared in the event that two or more do eventually go to college, then you can start with the Roth IRA plan as in the previous paragraph. By maximizing Roth IRA contributions for both you and your spouse, there should be enough in the Roth IRA contributions to cover one child’s college education without having to tap into the Roth IRA earnings. Then open a taxable brokerage account in your own name that you earmark to tentatively use for a second child’s education. You will have to pay annual income tax on interest income and non-qualified dividend income and you will have to pay capital gains tax when you sell the investment (for most people, the capital gains tax rate is lower than their effective income tax rate). However, these taxes will be less than the income tax and 10% penalty that you would have to pay if you had put the money in a 529 plan and then withdrawn the 529 earnings should your children not attended college.

The child is not going to college but will have other monetary needs after high school. Maybe your child’s dream is to open a pet daycare center and will need seed money to start their business. Maybe your child wants to be an Uber driver and will need money to buy a car. Maybe your child is a sculptor and will want to travel abroad for for artistic inspiration. In these situations, a 529 plan is not a great idea because you cannot take the money out of the account without penalty since it will not be used for bonafide educational expenses. Uniform gifts to minors savings may be a better option since this allows the child to use that money to launch his or her career.

The most important thing you can give your child

I’m one of those people who thinks that his life is great but that the lives of the next generation are going to be even better. But more than any other time in human history, that depends on education. The most important gift a parent can give to a child is education and I prioritize education much more than gifts of things like clothes, cars, or exotic vacations. For me, Ohio’s 529 plan was clearly the best choice to save for my children’s education. For you, another option might be preferable. But whatever you decide to do, start saving early and save at least a little bit every month. There will come a time in your life when watching your children succeed in life is more important to you than your own successes.

March 19, 2024

By James Allen, MD

I am a Professor Emeritus of Internal Medicine at the Ohio State University and former Medical Director of Ohio State University East Hospital