PAYING FOR COLLEGE. Tactics change as costs soar

AMERICA'S middle class is getting a painful lesson in the economics of paying for college. Through the 1980s, the cost of college has risen more than twice the rate of inflation. Schools have been trying to make up for the 1970s when tuition increases fell behind inflation.

And more increases are coming.

``In the next few years, college costs will continue to rise faster than inflation,'' says Kaye Ferriter, a tax partner in the higher education group of Coopers & Lybrand, the accounting firm. ``There's a lot of catching up to do.''

Even though college costs stay fairly close to inflation over a span of 15 to 20 years, this pattern of falling behind and catching up ``makes it very difficult to plan,'' she says.

Meanwhile, the demographics of fewer students mean higher tuitions for those who are left. ``Between now and the mid-90s, the number of kids available to go to college will decrease by 20 percent,'' says Wade Webster, a financial planner in Cockeysville, Md.

As a result of all these changes, by the time today's four-year-olds finish high school, the bill for four years of college will top $90,000 - assuming the college inflation rate doesn't go over 5 percent a year.

While costs are climbing, other factors have made it even harder for parents to pay for future - or past - college bills. Families whose lower incomes make them ``fortunate'' enough to qualify for financial aid, for example, are finding colleges don't have as much aid to offer.

For parents who do have assets to shift to their children, tax reform has made it harder to get the lower tax rates this tactic used to provide.

And by ending most deductions for interest on loans, tax reform also made it more expensive for students, or their parents, to pay off college loans. Some parents may even find themselves saving less than they should for retirement because they borrowed so much to pay their youngsters' college bills.

``We're very much in danger that the combination of college costs rising and government funding drying up will make college unaffordable,'' Ms. Ferriter says. ``Families are already being stretched.''

Some professionals are worried that the US will soon be faced with a new class division: those who can afford to pay for college and those who can't. This latter group could be frozen out of the best jobs and relegated to the declining manufacturing sector.

``The way people are going to advance in this country is through education,'' says William Freund, a financial planner with Prescott Ball & Turben, a Cleveland brokerage. ``But if you don't have an education because you couldn't afford it, it will make for a have and have-not situation.''

Right now, however, many parents just aren't saving enough for college. A recent Roper survey found that the median amount of money families were saving for college was $904 a year, or $75.33 a month. But to have $90,000 for four years of college will require setting aside approximately $2,700 a year, or $225 a month, if the savings earn 6 percent interest. A higher interest rate, of course, will mean less has to be saved: $125 a month at 12 percent interest will reach $94,000 in 18 years, but clearly $75 a month just isn't going to make it.

``What's the best way to plan for college costs?'' Mr. Webster asks. ``Start early. On the way home from the hospital, a family with a new baby should stop off and begin a savings plan.''

For most people, Webster says, the new tax law won't make much difference in their ability to save. Under that law, the first $500 of interest or dividend income earned by a child under age 14 is tax-free. The next $500 is taxed at the child's rate. But any income over $1,000 is taxed at the parents' rate. When the child reaches 14, however, all this income is taxed at his or her rate. Before, all income earned by a child was taxed at the child's rate.

Even the $1,000 limit is not a bad start, however. If the account earns 8 percent interest, you can have up to $12,000 in it without a tax bite.

These tax changes should not affect most middle-income families, Webster believes. For them, the main goal in saving for college is not saving on taxes; it's paying college bills. And while the old tax break did help, it was more useful to upper-income people who could afford to pay college bills with or without help from Uncle Sam.

Still, if saving taxes is important, there are ways to accomplish this and build a nest egg for college, too.

Savings Bonds. Taxes on the interest on Series EE bonds can be deferred until the bonds mature or they are cashed in. The United States Treasury now pays a floating rate on the bonds, so if interest rates head up, your bonds won't be left behind.

Municipal bonds. Parents can already get tax-free income from municipal bonds, but they might consider buying discount or, zero-coupon bonds in their children's name. You can also invest in municipal bond mutual funds, but watch the fund's net asset value (NAV), or share price, carefully. While the yields may be attractive, the NAV can fluctuate widely, perhaps eating into your principal if bond prices fall.

Life insurance. You can use single-premium annuities, where a lump of money is deposited and the policy earns interest until it's time for college, or flexible-premium annuities which are paid for with yearly contributions. When the child goes to college, payments can be annuitized, or spread out, over a five-year period.

Beyond these tax-advantaged savings methods, many parents are seizing upon a product that got a major boost from tax reform: the home equity loan. The tax law allows a full deduction of a loan against the appraised value of a home for medical bills, college, or home improvements. So some families are using the value of their homes (minus any first mortgage) to pay college bills.

A risk here is that interest rates, and thus monthly loan payments, will rise. The interest rate on most home equity loans is pegged to the prime rate and as it changes, so do the payments.

Another risk is that parents might be mortgaging their own futures as well as their homes.

Prescott's Mr. Freund tells of a couple he knows who are in their 60s. ``They have mortgaged themselves to provide an education for their three children,'' he says. ``They are nearing retirement age and they do not have the assets they need. What I see is not nice.''

``They have so many college debts, the husband will have to continue working as long as he's able. When he's forced to retire, he'll have to find some other work. His wife will have to keep working, too.''

Parents have to be careful that they aren't ``paying for more education than they can afford,'' Freund adds. ``They have to put together the next piece. How are they going to retire?''