Paying for College : New Tax Laws and School Programs Test Parents’ Skill at Planning, Saving

NEW YORK â€”  None of the young Michigan couple’s four children is older than 6, but the college their parents hope that they will attend someday already has collected their college tuition in full.

For the $30,000 the couple borrowed against the equity in their home, Hope College in Holland, Mich., guarantees four years of college for each of the toddlers--assuming that they can meet the admission requirements when they’re old enough to enroll. Four years of college for four students at Hope already costs about $136,000.

Parents searching for affordable ways to finance their children’s college education in an environment of soaring educational costs and dwindling tax benefits have been forced to become more creative. So they are borrowing against the equity in their homes, buying growth stocks, investing in savings bonds and zero-coupon municipal bonds and even--as the Hope College case illustrates--giving money to schools many years in advance in hopes of forestalling further tuition increases.

Poses Problem

Although advisers say these options are the best still available to parents now that tax reform has undermined the usefulness of the most popular college-savings schemes, none is a panacea.

Investment advisers only recommend prepaid college tuition plans, for example, to the very conservative investor: Parents or grandparents who don’t want to hassle with watching over their investment and who fear falling short of the actual schooling expenses if they don’t take advantage of the prepaid tuition plans now. Both Duquesne University in Pittsburgh and Hope say their tuition futures participants overwhelmingly are grandparents and parents with newborns.

“We admit that it’s a little bit of a gamble on both sides,� said John Fedele, a spokesman for Duquesne, believed to offer the first tuition futures program in the country.

If tuition costs rise faster than the school predicts or if the college’s investment of the prepayment falls short of expectations, the college suffers. And if the child fails to make the grade, selects another school or doesn’t want to go to college at all, the parents may not get all of their money back and, at best, must forfeit the interest on their investment.

Amassing such a large up-front sum poses another problem for parents who choose this route, as does the uncertainty over whether the Internal Revenue Service will start taxing the income earned by the prepaid tuition contributions.

The state of Michigan, which is designing an umbrella tuition futures program under which parents could pay for four years of schooling at any Michigan college or university for as little as $4,000, has asked the IRS for a ruling on the taxation question and hopes to get a response soon. Also awaiting the outcome of the ruling are Indiana, Tennessee, Maine and Florida, all of which have plans on the drawing board, and Wyoming, the first state to offer a statewide prepaid tuition program.

Tax considerations have always been important for parents trying to salt away money to put their children through college. The less one has to fork over to the IRS, the more that goes toward the student’s education and the faster compounded interest accumulates.

Other Options

But with the advent of tax reform, financial advisers say parents are spending more time than ever before searching for tax-advantaged vehicles for college savings. That is because the investment earnings of children under age 14 now are taxed at the parents’ rate instead of at the child’s lower rate. Also, one of the most popular ways for parents with foresight to save for college many years in advance--the Clifford Trust--was undermined by tax reformers.

A Clifford Trust permitted parents to put income-producing assets into a trust fund for their children, pay little or no taxes on the income that accumulated because the tax was figured at the child’s low tax rate, give the income to the children for college and take back the assets for themselves when the trust ended at least 10 years and a day later.

Parents can still set up such trusts. But these are no longer attractive as tax-advantaged vehicles for college savings because the income now is taxed at the parents’ higher rate.

As a surrogate, financial advisers were steering parents toward growth stocks that pay no dividends because the increase in the stocks’ value wasn’t taxable until the shares were sold. Hence, parents could save money for college tax-free by keeping the stock at least until the child turned 14--at which point earnings on cashed-in stock are taxed at the child’s rate.

But in the aftermath of the Oct. 19 stock market crash, some advisers are steering clear of stocks, favoring instead variable life insurance policies--which provide money for college tax-free as long as the policy is in force--tax-free municipal bonds or tax-deferred savings bonds for parents who have many years to save before their children head off to college.

For those who lack the money or sophistication for such savings plans as tuition futures, bonds or variable annuities, or who didn’t plan far enough in advance, there are the home equity loans or new types of financial aid plans through certain colleges and universities.

The home equity loan has become popular for financing college expenses, tax advisers say, because the interest expense on such borrowings is still tax deductible. Conversely, interest on most other consumer debt is no longer fully deductible and, beginning in 1991, won’t be deductible at all.

But tax deductibility shouldn’t be the only consideration when borrowing for college, cautions Gregory P. Kushner, director of executive financial services at the Los Angeles office of Price Waterhouse & Co. With a home equity loan, the borrower’s home is at risk in the event of a default and a 5% loan whose interest isn’t deductible is still more attractive than a 12% loan whose interest is, he noted.

Stanford, Harvard and Duke are among the universities that will lend students up to $15,000 a year with 20 years to repay through a private nonprofit institution called Nellie Mae Inc. The fixed and variable rates available aren’t any more favorable than the going rate for a home equity loan, but they do have the advantage of not putting the borrower’s home at risk.

Some smaller colleges offer more attractive rates. Duquesne lets students finance their tuition and room and board with a 5% loan backed by home equity or other collateral.

Where investment convenience is an important consideration, David S. Rhine, a tax partner in the New York office of the Seidman & Seidman/BDO accounting firm, recommends zero-coupon municipal bonds--which have no coupons to clip, so require no attention after they are purchased--and Series EE U.S. savings bonds, which are risk-free and aren’t taxable until they are cashed in. The redemption of savings bonds can be timed so that the tax is postponed until the child is 14 or older and the interest is taxed at his rate instead of at his parents’ presumably higher one.

Zero-coupon bonds also are attractive for parents saving for college because the investor knows precisely how much money his investment will earn, Kushner said. The investor buys zeros at a deep discount to their face value and collects the face value upon maturity.

Their drawback is that because the entire yield is collected at maturity, their market value in the interim can be extremely volatile, Kushner noted.

COLLEGE COST WORKSHEET

What will college cost for your children? This worksheet will help you estimate that--and how much you may need to invest to meet your target. A hypothetical child, “Jane Smith,� is presented as an example.

Your Jane Child Smith 1. Enter your child’s age 6 2. Years to college: time to invest (18 minus child’s age) 12 3. Annual college costs* a. Enter your own estimate or b. $6,000 for public schools or c. $10,000 for private schools $6,000 4. College inflation factors: According to the College Board, college costs are increasing 6% per year. Refer to Table 1 for the inflation factor based on your child’s age 2.02 5. Future annual cost of college Step 3 x Step 4 $12,120 6. Future total cost of college: Step 5 x number of years of college $48,480 How much should you invest? 7. Assumed rate of return (10%) Take the number of years your child has until college, refer to Table 2, and enter your return rate factor 21.38 8. Annual target amount to invest Divide Step 7 into Step 6 $ 2,268 9. Monthly amount to invest: Divide Step 8 by 12 $189

Table 1: Inflation Factors

The current yearly rate of college inflation is 6%, according to the College Board. To find the factor by which inflation will increase college costs over the years, select the appropriate figure in the left column, find the inflation factor to the right, and enter the proper factor on line 4 of the worksheet.

Years to Years to Start of Inflation Start of Inflation College (6%) College (6%) 1 1.06 10 1.80 2 1.12 11 1.91 3 1.19 12 2.02 4 1.26 13 2.14 5 1.34 14 2.27 6 1.42 15 2.41 7 1.51 16 2.55 8 1.60 17 2.70 9 1.70 18 2.87

Table 2: Return Rate Factors While no one can predict the future value of an investment, you must assume some rate of return to estimate your investment target. To determine the factor by which a 10% rate of return, compounded annually, increases your investment, select the appropriate figure from the left column, find the return rate factor to the right, and enter rate on line 7 of the worksheet.

Years to Factor: Years to Factor: Start of Rate of Start of Rate of College Return College Return (10%) (10%) 1 1.00 10 15.94 2 2.10 11 18.53 3 3.31 12 21.38 4 4.84 13 24.52 5 6.10 14 27.88 6 7.71 15 31.77 7 9.49 16 35.95 8 11.43 17 40.55 9 13.58 18 45.80

*According to the College Board, these were the approximate annual costs of public and private colleges for the 1986-1987 school year.

Source: Fidelity Investments