Some Options on Saving for College

QUESTION: I’d like to prepare myself now for my son’s college expenses. He turns 5 this year, but age 18 will be here before I know it. What is the best way to prepare for this enormous expense? Should we start saving now and, if so, in what type of instrument? Or maybe we should just take out a home equity loan when the time comes. We could sure use some advice.--A. R.

ANSWER: With back-to-school nearly upon us, your question is a timely one.

According to the Education Commission of the States, parents can expect to spend about $4,500 a year right now to send a child to a publicly supported college. For a private college education, the cost jumps to an average of $11,500 a year. And the costs are rising: 7% this year alone.

So, say our experts, now is the time to begin taking steps to finance your son’s college education. Your ability to save and the type of instruments best suited to you depend on your family income and other factors. We’ll run down several choices, many of them outlined by Thomas Gau of the Torrance financial planning offices of Kavesh & Gau.

But first, Gau notes that whatever you choose, you should attempt to minimize the effect of the so-called kiddie tax on investment income of children under age 14. You will recall that under the 1986 tax revisions, only the first $500 generated each year by a child’s investments is tax free. The next $500 is taxed at 15%. Anything more is taxed at the highest rate paid by his parents. So, Gau counsels, your goal should be to generate tax-free or tax-deferred income until the investments can be cashed in after the child reaches age 14 and is treated the same as any other taxpayer.

Perhaps one of the most popular methods of financing college expenses is through a universal life insurance policy. If properly set up--and this is an all-important caveat--these policies can generate tax-free interest that can be withdrawn when a child enters college.

However, be warned: This method should only be used if the parents do, in fact, need a life insurance policy, and these policies should only be purchased on the advice of a qualified financial planner or another competent and trusted financial adviser. “Do not be tricked into thinking you need extra life insurance just to take advantage of the tax benefits of these policies,� Gau says. “There are other ways to save for your children’s education.�

Other popular savings instruments are municipal bonds. If you invest in bonds issued by public agencies in your own state, the interest generated by the bonds can be completely tax free. (This is the case in California.) Of course, you’ll want to do your homework and consult a trusted professional before investing in muni bonds, whether individually or through a mutual fund.

Still other families invest their children’s education funds in the stock market, usually through one or more mutual funds. Again, before making an investment, you should research various funds and evaluate how they have performed in the past and what fees they charge for participating in the fund.

If you own your own business, you might want to think about putting your child on your payroll. His wages would be a business expense to you, and earned income up to $3,000 can be tax free to a child.

However, Gau cautions you to be reasonable if you take this route. Obviously, an infant or toddler can’t be a great value to a business, but some company owners have been known to use pictures of their kids on promotional brochures and pay the children modeling fees. Older children can be hired as janitors, office help or shipping clerks. The key, Gau advises, is not to pay the children more than what they’re worth in the open market because the Internal Revenue Service is well aware of the potential for abuse.

Recognizing the difficulty that many middle-income families have in preparing for college educations, Congress has established a special U.S. Savings Bond program. Beginning in 1990, interest earned on Series EE bonds issued after Dec. 31, 1989, can be free from federal taxation if they are redeemed to pay for college or vocational school.

However, there are several restrictions. Bond buyers must be at least 24 years old and the tax break will apply only to bond proceeds used for tuition and required school fees--not books or room and board. In addition, it will apply only to degree programs at colleges, universities and certain vocational schools.

Finally, the tax break can be used only by families and individuals who do not exceed certain income limits. For couples filing jointly, a $90,000 adjusted gross income is the cutoff; for individual filers, the cutoff is an annual adjusted gross income of $55,000. These tax breaks are available only for bonds purchased by the parents of the children attending college, not any other family members or interested outsiders.

Many states are offering residents special college financing programs. Eight states have approved prepaid tuition plans: Alabama, Florida, Indiana, Maine, Michigan, Oklahoma, West Virginia and Wyoming. However, only three states--Florida, Michigan and Wyoming--have actually put the plans into effect. Under these plans, parents are allowed to pay tuition at state-supported schools years in advance. Although admission to the schools is not guaranteed, if the child is accepted, the prepaid tuition is considered full payment, regardless of the rates then in effect.

A similar plan is again pending in the California Legislature, although its fate is far from certain. For the past two years, the bill, sponsored by Assemblyman Tom Hayden (D-Santa Monica), has been approved by both legislative houses only to be vetoed by Gov. George Deukmejian. Hayden’s bill would allow parents to prepay tuition at state colleges and universities. If the child does not attend a state school, the payment, plus interest would be refunded, minus an administrative fee.

Deukmejian has twice vetoed the bill because of concerns that it could put the state in a future financial bind. The bill envisions that money invested in the tuition fund could earn 12% a year, while tuition costs at the state schools would rise 9%. This year, Hayden’s latest version of the bill has passed the Assembly and is awaiting hearing in the Senate. Hayden’s staff has urged interested parents to contact the governor to express their opinions on the legislation.