Planning for college education.

As students head back to school, it's time to revisit the question of how to meet soaring college costs.

Today, a child's ability to go to the college of his or her choice involves more than just getting good grades or writing the perfect application essay. The upward spiral of tuition and room and board means cost is more of a factor than ever before. While most parents want their children to attend the school of their choice, many either fail to plan in advance for the expense or are unable to cope with costs that are rising faster than the inflation rate.

CPAs can help clients plan for their children's education in a number of ways, which requires them to understand trends in college costs, the financial aid process, tax issues and investment alternatives. Failure to adequately consider the potential impact of each on a particular situation can undermine even the best plan.

What can go wrong? A recommendation to transfer assets into a child's name to minimize income taxes may reduce the students' financial aid eligibility. Using Series EE savings bonds in a college fund may be inadequate since college costs are rising at a rate that often exceeds these bonds' aftertax yield. This article explores these and other issues to help CPA-financial planners provide clients of all income levels the best possible education funding advice.

RISING COLLEGE COSTS

It is first necessary to consider current college costs and expected future changes. According to the College Board, the average annual cost of a four-year public college in 1995 was about $9,000, which includes tuition, fees, books, supplies, room, board and transportation. The average cost for a four-year private college was about $18,800. The College Board says costs have been increasing at 6% annually. And given recent trends in higher education and employment-- with many professions requiring advanced degrees--CPAs also should consider that graduate or professional school funding may be needed.

CAN FINANCIAL AID REALLY HELP?.

Financial aid consists of federal grants, loans and work-study programs. Additional programs are available at the state level, from colleges themselves and from private groups.

Aid eligibility is based on education costs less the expected family contribution, which is determined based on the income and assets of both the parents and the student. Parents are expected to contribute part of their adjusted available income--taxable and nontaxable income plus 12% of discretionary net worth--less an allowance for family living expenses, including taxes.

At the highest income level, parents would have to contribute 47% of their income and 5.6% of their discretionary net worth to meet their children's education needs. Students are expected to contribute 50% of their available income from investments, summer or part-time employment, etc. and 35% of any assets. Accumulating assets in a college fund will, therefore, reduce the aid a student receives. Because the contribution rate is higher, this will be especially true if the assets are held in the student's name.

The timing of investment sales also should consider the financial aid process. Ira student's college fund consists of growth stocks that are sold in the current year, the amount of aid the following year will be substantially reduced because college aid rules consider income only in the year immediately preceding the year of application. Therefore, sale during a child's junior year of high school or before can avoid this problem.

Families with a high net income and net worth often are not eligible for aid regardless of the rules, making tax-advantaged advance funding particularly appropriate. How high is high? Under current guidelines, for example, a family with $80,000 of income and $50,000 of discretionary net worth would have an expected contribution of about $15,400 annually. This would make a student eligible for some aid assuming he or she planned to attend an average private school.

If children of wealthy parents receive financial aid, it is most likely to be limited to student loans or merit scholarships. For clients unlikely to receive financial aid, the planning focus should be on tax minimization strategies such as the transfer of income-producing assets to children. (For a discussion of vehicles for making gifts to children, see the sidebar on page 93.)

TAX PLANNING ISSUES

It is important for CPAs to help clients develop comprehensive tax minimization strategies after considering nontax factors such as family relationships, financial aid and investment considerations. For example, a client may prefer not to make gifts to children despite favorable income, estate and gift tax consequences because of a concern about losing control over the assets. In addition, the advantages of tax-favored investments may be minimized by the client's investment preferences. A client may, for example, prefer not to invest in high growth common stock despite the potential for favorable capital gain and income tax deferral opportunities.

It is helpful for CPAs and their clients to consider different tax-favored investment strategies during three distinct periods

* Early years through age 13.

* High school years, ages 14 to 18.

* College years.

Strategies for early years.

The tax rates of the parents and their children, opportunities for tax deferral and control over the management of any assets given to children are key considerations during this time. An important concern is avoiding the so-called kiddie tax whereby unearned income over $1,300 of a child under age 14 is taxed at the parent's tax rate. Assuming the child has no earned income, the first $650 of unearned income is not taxed because it is offset by the child's standard deduction. The next $650 is taxed at the child's 15% rate and the remainder is taxed at the parent's rate--which may be as high as 39.6%.

The kiddie tax can be avoided by making gifts of low dividend, high growth stock during the child's first 14 years or by giving cash, which is in turn invested in growth stocks. For example, a parent might transfer $130,000 of stock to a child without incurring the kiddie tax if the stock's dividend yield is only 1%. The $1,300 of dividend income would then be taxed to the child at an effective rate of only 7.5%.

Series EE savings bonds also can be used to avoid or minimize the kiddie tax. Bond owners have the option of reporting interest annually or can defer recognition until the bonds are redeemed or mature. One strategy might be to elect to report the interest on an annual basis until the amount per child reaches $1,300. At this point, revenue procedure 89-46 says the child can switch to the deferral method without Internal Revenue Service approval. Another strategy would be to defer interest until the child reaches age 14 and the kiddie tax no longer is a factor. However, because the current interest rate on Series EE bonds is about the same as or less than recent increases in college costs, even on a pretax basis, it would be difficult to accumulate adequate education funds using only these bonds. Additional funding would be needed.

For middle-income taxpayers, it may be desirable to hold Series EE bonds in the parents' name rather than give them to the children. Internal Revenue Code section 135(c) says bond interest is partially or entirely excluded from the owner's income if the redemption proceeds are used to pay qualified education expenses for a dependent child. The value of this exclusion is questionable, however, because it is phased out at relatively low income levels and the income ceilings are imposed in the year the bonds are redeemed.

High school years. Income tax planning strategies change during this period. At age 14, the kiddie tax no longer applies so any unearned income over $1,300 is taxed at the child's rate. In 1996, a child's tax rate on income up to $24,000 is 15%, making income shifting to the child generally a good strategy. As college approaches, it may be advisable to change the investment portfolio mix from equity securities and long-term debt to shorter term fixed-income securities to minimize risk. When sold during this period, high-growth stocks given to the child in the early years may produce favorable tax consequences. Appreciated stock held by the parents also may be given to a child before sale; capital gains may then be taxed at no more than 28% and at 15% if the child's taxable income is less than $24,000.

During the high school years, employing a child in a family business may have favorable tax consequences by shifting income to a lower bracket taxpayer and increasing college fund accumulations if the child's wages are saved. Reasonable salary payments are deductible by the employer and taxable to the child at a low rate. In many cases, the wages are not taxed because the child's standard deduction is the greater of earned income (up to the standard deduction amount of $4,000) or $650. These amounts are adjusted annually for inflation.

In addition to income tax savings, self-employed parents can realize payroll tax savings by employing their children. A minor child employed in a parent's sole proprietorship is not subject to FICA taxes on salary or wages. In addition, wages paid to the child decrease the parent's self-employment earnings for FICA purposes.

Another more sophisticated income shifting technique is to make a gift of a family partnership interest or ors corporation stock (subject to certain restrictions) to a child, whereby a distributive share of the business' income is taxed to the child.

College years. It is not unusual for CPAs to encounter parents who have children about to enter college and who have failed to accumulate adequate funds to pay the expenses. In such cases, the parents may want to consider a home equity, loan of up to $100,000. By the time a child is 18 years old, parents usually have substantial equity in their home. Interest payments are tax deductible and the aftertax cost of borrowing may be lower than prevailing student loan rates. During this period wages from working for a family business also are to be a tax-advantaged way to help meet college expenses.

INVESTMENT ALTERNATIVES

A large variety of investment alternatives is available but the client's risk preferences must be balanced with the portfolio's needed and expected returns. Over the long term, equity investments generally have returned more than bonds. While there is risk associated with equities, a carefully selected stock mutual fund or a portfolio of common stocks can provide commensurate returns. If bonds are selected, care must be taken to match the portfolio's duration (not its maturity) to the time the child will enter college, to minimize risk. (Duration refers to the weighted average term to maturity, which generally is shorter than the full term to maturity.)

As discussed previously, Series EE bonds often are touted as the solution to a college fund but may not provide a sufficient yield. Certificates of deposit have similar problems. Some private purpose banks have developed CDs whose yields are tied to the inflation rate for college costs as computed by the College Board. Several states have developed prepaid college plans to reduce the uncertainty of future investment returns and college cost inflation.

Under Florida's prepaid college program, for example, a current lump-sum payment of about $6,000 for a four-year old child will pay for four years of tuition at a Florida state university beginning in 2008. The Florida plan allows the value of the contract to be transferred to a private college or to an out-of-state school, with some restrictions. If the student does not attend college, the original investment is returned without interest. Other states and even some private colleges have experimented with similar plans, not all of which have been successful. It is important to carefully examine the features and risks of any prepaid tuition program and to determine whether the state government is backing it financially.

COMPUTING FUNDING REQUIREMENTS

Once college costs, inflation, financial aid, taxes and investments have been considered, it's possible to calculate how much a family must invest today, annually or monthly, to accumulate funds for college. While some families may choose not to accumulate funds in advance and take their chances with financial aid or a pay-as-you-go plan, calculations like those shown below can still be used to demonstrate to them what future costs are likely to be.

The exhibit on page 92 provides an example of funding needs and requirements for 12-year-old Danielle Jones. Assuming six years until college starts, private school tuition of about $18,000 and a 6% inflation rate, the cost of Danielle's first year of college will be $25,533. Each subsequent year is expected also to increase at 6%. If funds are invested at 8% an aftertax return, the inflation-adjusted rate of return is 1.89% during the college years and the Jones family will need to accumulate a college fund of $99,331 by the time Danielle enters college to fund all four years if all assumptions hold. These calculations assume no financial aid and no additional funding once she enters college.

To accumulate $99,331 in six years, a family would need to make a lump-sum investment (at 8% after tax) of $62,596 today or 6 payments of $13,540 at 8% at the end of each year or 72 payments $1,089 at the end of each month. Funding in this example does not begin until Danielle is age 12. If funding were to begin at age two, with all other assumptions held constant, the annual payments would be reduced to $5,866.

ALTERNATIVE FUNDING SOURCES

For parents who need last minute help, one loan source is the parent's 401(k) retirement plan or a life insurance policy. Many 401(k) plans allow participants to borrow up to one-half of the account balance and offer flexible repayment arrangements. However, interest payments are not deductible and too much borrowing from retirement accounts may be detrimental to the parent's retirement savings objectives. Interest on life insurance loans also is not deductible. Policy loans can interfere with estate planning by reducing liquidity.

Student loans such as Stafford loans also should be considered. These loans are available through banks, credit unions and savings and loan associations as well as directly from some universities. Interest is added to the principal amount unless subsidized due to financial need. Eligibility for subsidized loans is determined by a school's financial aid director. Interest payments, however, are nondeductible personal interest. Tax-free scholarships, such as those provided by alumni organizations should be viewed as an ancillary source of funding. And students also should consider work-study programs or other part-time or summer employment.

HELP Parents who have elected--perhaps by default--the pay-as-you-go plan can provide testimony to how painful a way it is to meet college costs. Unfortunately, until they have had this experience, some clients may not understand how much they need a CPA's help with college tax planning, funding and investment alternatives. The case study on pages 94-95 tells the story of one practitioner who offers a full array of college planning services, including identifying scholarship sources and filling out the necessary financial forms and applications. His biggest problem? Making prospective clients understand how much they need his services.

College Funding for Danielle Jones

Facts and assumptions
Child's age ...........................................12
Number of years remaining before college .............. 6
Number of years in college ............................ 4
Estimated inflation rate for college costs ............ 6%
Estimated aftertax return on investments .............. 8%
Estimated current cost of college per year
(net of financial aid) ...........................$18,000

Calculations

Cost of first year in college
   Future value of current cost at 6%for 6 years .. $25,533
Inflation-adjusted rate of return .................   1.89%
1 + aftertax return
______________________ -1
1 + inflation

Amount needed at the time Danielle enters college
Present value of an annuity due of
$25,533 for 4 years at 1.89% ..................... $99,331

Lump sum needed today to fund above amount ...............
Present value at 8% for 6 years ...................$62,596
Or annual end-of-year deposits ....................$13,540
Or monthly end-of-month deposits .................. $1,089
(Monthly return of .644% to yield 8% annually)

Adapted from AICPA Persona/Financial Planning Manual, Vol, 1-3, 1993.

  The Rising Cost of a
  College Education

  Tuition up ............................253%
  Medical care up .......................182%
  Overall inflation up ...................80%

Source: Bureau of Labor Statistics

From 1980 to 1994, the increase in college tuition has far exceeded the consumer price index and the increase in medical care costs.

EXECUTIVE SUMMARY

* FOR MANY YEARS, COLLEGE COSTS HAVE risen faster than the inflation rate. If parents want to keep up, planning is essential to ensure the necessary funds are available when needed. CPAs who understand trends in college costs, the financial aid process and related tax and investment issues are in the best position to help clients plan for this future expense.

* FINANCIAL AID CAN PROVIDE TUITION assistance to some families, even those who think they' might not be eligible. Children of wealthy parents can receive help in the form of merit scholarships or student loans.

* TAX AND INVESTMENT STRATEGIES differ during three distinct periods: through age 13, between ages 14 and 18 and the college years.

* AMONG THE INVESTMENT VEHICLES that might be appropriate are Series EE savings bonds, long- and short-term fixed income securities and stocks. As an alternative, various borrowing options are available for parents who have not accumulated enough in advance to pay for college costs.

LAWRENCE C. PHILLIPS, CPA, PhD, is professor of accounting and Deloitte & Touche Accounting Scholar at the University, of Miami, Coral Gables, Florida. THOMAS R. ROBINSON, CPA, PhD, CFP, is assistant professor of accounting at the University of Miami.

Vehicles for Making Gifts to Children

A number of different techniques may be used to make gifts of property to children:

* A custodial account under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).

* A minor's trust under Internal Revenue Code section 2503(c).

* A Crummey trust.

A gift under the UGMA or UTMA is completed by transferring property to a custodial account for a minor child's benefit. A custodian, usually a parent or close relative, is appointed to manage the assets in a fiduciary capacity. The entire principal and accumulated income must be distributed to the minor when he or she reaches the age of majority (age 18 or 21, depending on state law). The gift is considered complete for federal income tax purposes, making any income taxable to the child. For gift tax purposes, section 2503(b) provides for a $10,000 annual per-donee gift tax exclusion. With gift splitting, a married couple may give $20,000. In addition, each spouse may use a unified estate and gift tax credit of $192,800, which is equivalent to passing $600,000 in property during life or at death.

Section 2503(c) allows parents to create trusts for children under age 21--commonly referred to as minors' trusts--that need not distribute all income annually. Any income and underlying assets must pass to the child when he or she reaches age 21. The amounts contributed are eligible for the annual gift tax exclusion. If trust income is not distributed to the minor, undistributed income is taxed to the trust. In most instances, it is preferable to distribute the income annually because trust income tax rates can be higher than the rates applicable to individuals.

Under a Crummey trust, the required income and principal distributions may be made at any age. As long as the beneficiary is given the power to demand a distribution of at least $10,000, the annual exclusion is available.

CASE STUDY

Helping Children Get What They Deserve

When speaking of his decision to make education planning part of his financial planning practice, H. William Kuehl, Jr. CPA, PFS, CFP, referred jokingly to his own "personal pain." He has seven children, and figured other people probably had the same trouble he did paying for college. Kuehl is one of three partners in a small firm in Richmond, Virginia. In addition to doing financial planning and tax return preparation, the firm has a small audit practice and an affiliate that is registered as an investment adviser to provide fee-only asset management.

A financial planning basic

Kuehl believes education funding is an important aspect of any financial plan if the client has children who are going on to college. His firm thought providing this planning would be a chance to help people not only identify. the funds they need to accumulate but also to determine their eligibility for financial aid. If the children are young, Kuehl's initial planning involves estimating college costs and the savings level the parents should try to achieve to meet them. For many, the amount is so high it becomes discouraging. How the money is invested also is important. "We identify the investment strategy they should adopt both for money they have already accumulated and for future savings," Kuehl said. For high school age children, Kuehl's firm offers additional services. At this stage the emphasis is on determining what colleges the student wants to attend or what the family can afford. Kuehl uses software to focus the student's choices about college, analyzing factors such as location, size and academic standards to make recommendations. But he said most juniors and seniors already know what college they want to attend. "It's rare that you select a school based on a questionnaire."

The next stage is financing the student's choice. Kuehl has found the best funding source is the school itself. "There often are scholarships the financial aid officer has in his or her bottom drawer that are not publicized." Their availability depends on the appeal made. Another source is regional scholarships, plus those available through area businesses, for students with specific professional goals--education, accounting, medicine, etc. and those of a particular religious or ethnic background. Kuehl said most parents don't prepare until the last minute and then it's usually too late to apply for aid. The service his firm offers is time oriented; "we meet all deadlines, provide the necessary letters, give families application information and the conditions they must meet and the encouragement needed to get the child to do their part (write essays, etc.) and for the parents to supervise them." The financial aid process begins with filling out the appropriate financial aid form--whether or not the family is seeking aid based on need. Because these forms can be difficult to prepare, Kuehl's firm also provides that service.

The firm's track record is good, Kuehl said. "Everyone who has used our service has gotten substantial financial aid." In one case, a student was second in his high school class and the guidance department said it could get him a full scholarship to the University of Virginia. However, the student wanted to attend Washington and Lee University, which is smaller and more focused in his area of interest. The parents had a combined income of $70,000 but had two other children to educate, so Washington and Lee's $25,000 to $30,000 annual cost would have been too much. Kuehl's firm helped the student get a full four-year scholarship.

Is there a market?

Kuehl admits it hasn't, been easy marketing his firm s college planning services. One reason may be that "apparently people are not suffering enough," and are able to pay tuition out of current income or borrow. Kuehl said prospects generally have not responded to offers for a free initial consultation or for seminars. "We contacted every area high school in the Richmond area--about 50 schools--and only 4 responded to our offer to do a seminar." Kuehl said he charges only $350 for the full financial aid service. While it would not be highly profitable at that price, he said, "we hoped it would lead to other services." Right now, existing clients are Kuehl's primary market. When these clients hear about the services the firm provides, some are willing to pay the fee. But the response has not been overwhelming. Kuehl thinks his upper middle class clients may be embarrassed to apply for financial aid. "We've told our clients that for every trip they make to the financial aid office, they could get $1,000." If the client keeps appealing the award, Kuehl said, and asks for additional money--emphasizing that their own retirement is in jeopardy or they have other children to educate-they may get more.

Getting started

Kuehl is involved at the initial meeting with the parents and then turns it over to a paraprofessional. A highly skilled technical staff member generally is not required to do the work, "just a good communicator who has common sense." The family fills out questionnaires identifying college preferences, religious and ethnic background, etc. The paraprofessional inputs this information and generates reports that are used to outline the client's responsibilities. These include

* Providing a copy of the most recent federal tax return.

* Providing details of all assets and liabilities, including a list of life insurance policies.

* Assembling background data needed to complete questionnaires and financial aid forms on a timely basis.

* Visiting financial aid offices at selected schools.

The parents must be monitored to make sure they provide this information and sign various financial aid forms or letters and mail them to institutions and scholarship funds. It's a job a paraprofessional can easily do, he said. On the back end there usually are accolades. "Clients say it's the best money they ever spent."

A look to the future

At the rate college costs are rising, Kuehl said in 5 to 10 years the cost of educating children is going to be even more dramatic in relation to income than it is today. "I don't know how people are going to be able to handle it, but I feel the market for this kind of service will grow as a result. CPAs can play a critical role in helping people make good financial decisions:'

--Peter D. Fleming

Resource Guide

 Computer
 Peterson's College Software, Princeton, NJ
 (HTTP://www.Petersons.com)
   Financial Aid Search (FAS)
   College Selection Search (css)
 Internet
 Fin-Aid: The Financial Aid Information Page
 HTTP://www.Finaid.org
   Includes access to Fast WEB (Financial Aid
   Search Through the Web), a searchable database
   of more than 180,000 private sector scholarships,
   fellowships, grants and loans.
 Publications
 College Admissions Data Handbook
   Four volumes, Orchard House, Inc.
 Paying Less For College 1996 (The Complete Guide
   to Over $30 billion in Financial Aid)
 Peterson's Guides, Inc.