How to provide for the cost of a college education.

HOW TO PROVIDE FOR THE COST OF A COLLEGE EDUCATION

With the cost of a college education expected to continue rising rapidly in the immediate future, Keith R. Fevurly, CFP, an attorney and an academic associate with the College for Financial Planning in Denver, discusses how proper advance planning can help parents meet this staggering expense.

The cost of a college education is rising faster than the rate of inflation. During the past 30 years, costs at both private and public institutions have increased at an annual rate of 7.4%, far outpacing the general inflation rate of only 4.8%. The American Council on Education estimates by the year 2000 the total cost of tuition and fees, room and board and miscellaneous expenses for four years will be $104,800 at the average private college or university and $52,400 at a corresponding public institution. Given these figures, parents must develop a savings program to accumulate the funds necessary to meet these expenses.

The exhibit on page 83 shows the projected cost and required funding for four years of college during the next 16 years.

FUNDING METHODS

Historically, the three means of financing a child's college education have been

* From the current income of parents or relatives.

* With student loans, grants or scholarships.

* From a parent or relative's personal savings.

In recent years, a fourth way to provide for college education expenses has been introduced. Prepaid tuition plans, currently offered by four states (Michigan, Florida, Wyoming and Alabama), promise to cover the cost of four years at a state school when the child is ready to attend. However, such plans have recently been under attack by the Internal Revenue Service. Until they can be structured to achieve favorable tax treatment (or Congress enacts legislation to encourage their adoption), it's probably best to avoid prepaid tuition plans.

Of the first three funding methods, the ability to draw from one's personal savings, particularly if the funds are earmarked for college, is clearly superior. Using current income-the "pay as you go" method -is expensive, since it fails to account for the time value of money. Similarly, relying on student loans, grants or scholarships has some disadvantages. The availability of such money has diminished in recent years because of federal budget cutbacks, a trend likely to continue.

What, then, is the best way to structure a savings plan to fund college expenses? The answer involves two elements:

* Maintaining the funds in a manner that will take maximum advantage of tax deferral opportunities.

* Selecting proper investment vehicles to achieve the greatest possible return.

DIRECT TRANSFERS AND CUSTODIAL ACCOUNTS

In formulating a college savings plan, it's wise to consider how the funds will be held for the child's benefit. This leads to a consideration of income shifting, a process typically accomplished by either transferring funds directly to the minor child's control or establishing a custodial or trust arrangement on behalf of the child.

A direct transfer of assets into the child's name is simple, inexpensive and avoids taxation of the income at the parent-donor's presumably higher marginal tax rate. A direct transfer also works well if certain investments-for example, series EE government bonds-are the subject of the gift. In that case, taxes may be deferred until the child is of college age.

Custodial accounts are a second way of building a college fund. Sometimes referred to as a "poor man's trust," since they have virtually no administrative costs, custodial accounts involve naming an individual as the manager of property belonging to a minor child. There are two types of custodial accounts. Assets can be set aside in

* A state-sanctioned Uniform Gifts to Minors Act (UGMA) account.

* In some states, in a Uniform Transfers to Minors Act (UTMA) account.

A practitioner should consult individual state law to determine which of these custodial arrangements is in effect in his or her state.

To most parents, a custodianship is preferable to a direct transfer of property to a minor. Almost any type of property may be placed under a custodian's care; however, in states where only UGMA has been adopted, some restrictions on permissible investments may apply.

Custodial arrangements also have some disadvantages. The child-beneficiary must be given the right to possession of the property on reaching the age of majority (age 18 in most states). This must occur even though the beneficiary may choose not to use the funds for his or her college education, a choice that is usually contrary to the donor's wishes. Also, a custodial account is relatively inflexible in avoiding the so-called kiddie tax, which provides for taxation at the parent's top marginal tax rate of any unearned income above $1, 000 of a child under the age of 14. A formal trust is a better way to minimize these problems.

TRUSTS

Trusts used in college education funding come in three basic forms:

* A "minor's trust," established under the provisions of Internal Revenue Code section 2503(c).

* A "current income trust," structured according to the terms of IRC section 2503(b).

* A demand or Crummey invasion trust.

A minor's trust is designed to use the $10,000 ($20,000 for a married couple) annual gift tax exclusion, although it may permit accumulation of income on behalf of the child under the trust terms. Its form is dictated by section 2503(c), which provides that a gift to an individual under 21 will not be considered a gift of a future interest as long as the property and its income are payable to the child at 21. In addition, the minor's trust permits income to escape the kiddie tax by allowing the trustee to accumulate more income at the trust's separate tax bracket, rather than have the income taxed at the potentially higher marginal rate of the parent.

The current income trust must have its income paid out at least annually to the beneficiary with no discretion left to the trustee to accumulate income. This typically presents problems in avoiding the kiddie tax; however, it has a substantial offsetting advantage to many grantors. The trust property, or principal, need not be distributed to the child at any specified age. This ensures the segregated funds are used only for the purpose they were intended, that is, the child's college education.

The final form of trust is the demand or Crummey invasion trust, which is an effective mix of the best attributes of the minor's and current income trusts. It permits the beneficiary to withdraw from the trust an amount equal to the lesser of the annual addition to the trust or the annual gift tax exclusion. In addition, rather than requiring trust property to be distributed to the beneficiary at age 21, the demand trust allows distribution at any age chosen by the grantor. Finally, the demand trust may accumulate income and have it taxed to the trust itself, allowing income to be taxed at a potentially lower marginal rate.

USING RETIREMENT

PLANS TO FUND

COLLEGE EXPENSES

An often overlooked means of saving for a child's college education is a parent's retirement plan. Specifically, many qualified profit-sharing or 401(k) plans permit a participant to use in the "growth period" of college funding is either a variable annuity or life insurance policy. In both these vehicles, the underlying account usually is invested in equities; however, unlike the growth mutual fund in a custodial account, ownership may be maintained by the parent, and tax advantages stiff can be achieved. With the annuity, a tax-deferred buildup of funds is possible, with payments geared toward the child's college entry date. With the life insurance variation, loans may be taken against the policy's accumulated cash value and used to pay college expenses.

When the child turns 14, the parents' investment strategy should change. The kiddie tax is no longer a concern and a high yield is important. Certificates of deposit, money market funds and bonds are among the potential investments. Some investment firms have created special "inflation-proof" CDs that guarantee the rate of return will match any annual rate of tuition increase. These are valuable if college tuition will continue to rise; however, if the rate of tuition increase is relatively low, it should be easy to get a better return elsewhere.

Money market funds provide a fixed return geared to prevailing market interest rates. Bonds come in all varieties, both taxable and tax exempt, and may prove profitable if interest rates are expected to decline in the near future. If held to maturity, bonds provide a determinable yearly income that may be used to pay college expenses. So-called zero coupon bonds also are often used, since they sell for a fraction of their ultimate value, yet return the full face amount at maturity.

START PLANNING NOW

The most important consideration in planning for college costs is to begin saving as early as possible. CPAs should recommend a simple plan to their clients and encourage them to stick to it. As in many other investment ventures, the key to success is the amount of time available and how well that time is used. As the exhibit illustrates, the earlier parents begin to save, the lower the regular contributions they will have to make.

EXECUTIVE SUMMARY * THE COST of a college education is rising faster than the inflation rate, forcing parents to implement a savings program to meet these expenses. * SAVINGS EARMARKED for college are the best way to meet tuition expenses. Loans, scholarships and grants have been cut, and the "pay as you go" method drains family resources. * CUSTODIAL ACCOUNTS or trusts are used to maintain money earmarked for a child's education. * FOR CHILDREN under age 14, investments should be selected to avoid the "kiddie tax." For older children, investments with a high current yield are desirable.