College planning: shake hands with the taxman.

One of the greatest financial planning challenges you'll ever face is funding your children's college education. Even high-income parents are frequently astounded by the astronomical costs. After you recover from the sticker shock, you might want to know that tax planning is an often-overlooked technique for funding your children's college education. For instance, before the 1986 Tax Reform Act, many high-income parents shifted some of their income to their children to maximize the family's after-tax income. TRA '86 dramatically reduced the top individual tax rate and introduced the "kiddie tax rules," which discouraged income-shifting.

But 1993 tax increases have brought us full circle. The current top federal tax rate has increased from 28 percent to 31 percent, and some states have increased their top state income tax rates, too. Also, the federal phaseout of exemptions and itemized deductions for high-income taxpayers insidiously increase the marginal tax rates. And Congress recently increased the top individual tax rates to 36 percent and 39.6 percent.

That's why it's a good idea to reexamine income-shifting as a valuable college-funding technique, even though the kiddie tax rules are still around. The family benefits from the lower tax rates, and the tax system encourages parents to shift income to a child by letting them retain their dependents' exemption, as long as they provide 50 percent of the child's support.

Before you race over to your accountant's office, however, take a moment to understand the basics of the income-tax and kiddie-tax rules. If you have children under 14 with "unearned" income, such as dividends, interest, royalties, rent or income from property, your tax situation will figure into your child's tax. Your top tax rate applies to your child's unearned income above $1,200. Children age 14 and older and young children with "earned income" are considered separate taxpayers, totally independent of the parents. Children with income get a standard deduction amount, above which they're taxed at 15 percent, 28 percent and so on, regardless of your tax situation.

While a dependent child can't take an exemption on his or her own tax returns, a standard deduction of up to $600 of taxable income or up to $3,600 of earned income is allowed in computing the taxable income. Thus, even for an under-14 child, the tax system encourages parents to transfer income-producing property, because the first $600 isn't taxed.

The 15 percent bracket for a dependent with income is also limited to $600 for an under-14 child with income from property. The first $600 is shielded by the standard deduction, while the next $600 is taxed at 15 percent. By contrast, if you hold title to the property, the same $1,200 of income could be taxed at 40 percent or more.

IT GETS BETTER

Children age 14 or older who earn income from gift property get even better tax treatment, because your marginal rates don't apply. In addition to the $600 standard deduction, each child has a full 15 percent bracket (approximately $21,000 of taxable income), a full 28 percent bracket and so on. Therefore, if you're wealthy and have large amounts of income-producing property, you might want to get the income out of your bracket and into your child's much-lower 15 percent and 28 percent rate brackets. Best of all, earned income from a child of any age receives a full standard deduction of up to $3,600, after which it is taxed at 15 percent, up to $21,000 of taxable income.

The table on page 16 summarizes the family tax savings possible from income-shifting. This is simply the difference between the taxed income on your return and on your child's. In addition, the table includes examples of possible marginal parental tax rates, which reflect the opportunity to save substantially on state or local income tax.

If you're in the 39.6 percent federal bracket, you'll find that shifting income reduces the phaseout of exemptions and itemized deductions, so deductions will increase as income is reduced. Thus, the federal tax impact for your bracket may be at least 3 percent greater. As the table shows, the tax savings from income-shifting can be as high as 48 percent. A dollar of income shifted from your return to your child's can save up to 48 cents in taxes, which could be used to help fund the child's education.

The tax savings available from income-shifting increases as your marginal tax rate increases. The higher your federal income-tax rate, the more steeply progressive the state and local income taxes. And the more your federal tax deductions and exemptions are impacted by income-related phaseouts, the greater the incentive to shift income, especially if the proposed federal increases take place.

The more income you shift, the more you save, except in the case of a young child with income from gift property. Here the tax savings remain at the same low level, no matter how much income you shift. Further, because income above $1,200 is taxed at your marginal federal tax rate, tax savings over the range of parental tax rates don't vary much. You can shift income by giving your child property, thereby removing the income that would otherwise be included on your return. But remember that you have to transfer the title, along with all other aspects of ownership and control, to shift property income to your child. Not everyone is comfortable doing that, so you may want to retain some of the property if your child is too young to handle all that money.

Also, you can set up a trust to own the property for your child's benefit. Or you can open an account under the Uniform Transfer to Minors or Uniform Gift to Minors Acts, although this involves some costs. In most cases, your child's access to the funds is deferred until age 21.

A FEW DRAWBACKS

Transferring property to your children does have some drawbacks. To transfer a dollar of income, the amount of property you need to give the child is several times larger. For example, if the property yields 7 percent, you'd have to give your child property valued at more than $140,000 to shift $10,000 of income. Such a large gift in excess of the annual gift tax exclusion may trigger gift taxes, another big consideration.

The second option is to hire your children at your business, which produces a deduction for the business and reduces its taxable income. This saves even more money because a larger standard deduction amount applies. The tax savings in this case don't depend on the child's age, although it's probably easier to justify the salary deduction for an older child.

If you're considering the earned-income approach, you must own your own business. Also, while hiring your children typically doesn't trigger the Social Security tax, you must allow for the possibility.

Furthermore, if you're paying your child to work in your business, the payment must be considered "ordinary necessary" and "reasonable" in amount. As long as the child actually works and the payment is fair, given the child's time, effort, age and skill, the Internal Revenue Service probably won't challenge the deduction. If you have an S corporation, partnership or proprietorship, the deduction offsets other income. Similarly, if you own rental property that's not subject to passive-activity loss limitations, paying your children to paint or cut the grass at the rental property produces deductions to offset the rental income. If you have a C corporation, your child's wages offset the corporation's taxable income, with savings at the corporation's marginal tax rate.

Some people don't want their children, especially young ones, working in their businesses. You may choose to not require the child to work, overpay for the work or simply transfer some of your earnings to the child's tax return. However, doing any of those things might jeopardize the income shift, because they could lead the IRS to consider the earnings the parents' income.

DAD, I WANT TO BUY A CAR INSTEAD

But perhaps the most critical consideration is convincing the child who earns the money to save at least part of it for college. If you don't have this degree of influence over your child's spending and are likely to hear, "But, Mom and Dad, I earned it, so why can't I spend it on a car?", then the tax savings can be minuscule compared to the family problems you're likely to have.

On the plus side, income-shifting can make children more aware of the benefits of saving and how to handle and invest money. Further, the experience of working can reinforce lessons about the value of saving. Perhaps paying for college costs would make your TABULAR DATA OMITTED child appreciate his or her educational experience all the more.

Once you start to get some results from income-shifting, you still have to choose how to invest the money you save. Investment vehicles to fund college expenses are numerous and diverse, and the decision is further complicated by how much time remains before you need the funds. With a long time horizon, growth mutual funds and diversified portfolios of individual common stocks are attractive. However, as college looms closer, less-risky investments, such as money-market and short- to intermediate-term bond funds, are best.

The taxability of the investment is also a factor. The goal of income-shifting is to accumulate as much money as possible by reducing taxes. Once the funds are in the child's name, the "kiddie tax" rules apply, so pick investments based on their after-tax returns. Many tax-advantaged investments don't provide the best after-tax returns, but they're often a good way to invest your college funds.

As you can see, accumulating enough money for your children's education is far from elementary. But armed with some good income-shifting techniques, at least you'll have a place to start.

Mr. Samson is professor of accounting and Mr. McLeod is an associate professor of finance at the University of Alabama in Tuscaloosa, Ala.