A look at new tactics to pay the way to college
Boston — The interest-free loan ''was the leading tax strategy for parents'' looking to save taxes with college funds. The emphasis, says Clark Bernard, chairman of Coopers & Lybrand's education-industry tax practice, is on the word was. For with the help of the courts and finally of Congress, the interest-free loan as a tactic to shelter college savings from Uncle Sam no longer exists.
Because of the tax law signed by President Reagan last month, it is no longer possible for parents to borrow the next year's tuition at the cheapest rate they can find; lend it free of interest to the child, who parks the cash in a money market fund; and have the loan repaid at some future date.
''With the interest-free loan, when little Bozo was about to start college, you could loan him $100,000 to see him through,'' says Gene Osborne, tax partner in the Boston office of Touche Ross & Co. ''Well, you can't do that anymore. The biggest impact of the demise of the interest-free loan is that it forces people to plan further ahead. I think we're probably back to some of the more traditional ways of saving for college,'' he says.
Here are some of those more traditional methods, which can also help protect savings from income taxes:
* Gifts. Giving assets directly to children is still one of the most frequently used tax-saving maneuvers. By making gifts, parents can shift all kinds of assets to children, up to certain limits, without being subject to federal gift tax. Income from these assets is reported and taxed in the child's name and at his own income level.
To qualify for this treatment, the account must be set up under guidelines of the Uniform Gifts to Minors Act. You may not need a UGMA account, however, because the tax act of 1981 raised the tax-free-gift limits to $10,000, meaning Mom and Dad can each give Bozo $10,000 a year without paying gift tax.
Also, be aware that if you plan to apply for financial assistance, any assets in the child's name count more heavily in a ''needs test'' than if they were kept in the parents' names. Thus, it may make sense to shift UGMA assets back to the parents before an aid application is filed.
* Custodianship. No legal work is needed here; you just open up an account at a bank, mutual fund, or brokerage in the child's name and start moving money into it. You or your spouse acts as custodian, giving you the right to manage the assets and use the income or principal to pay college bills.
This may sound like a UGMA account, but there's an important difference: When the child reaches the age of majority in your state (usually 18), the money is his to do with as he likes.
''The Uniform Gift to Minors is not as risky as a custody account, where, when the kid is 18 years and a day old, you're apt to see three Camaros in the driveway,'' Mr. Osborne jokes - sort of.
* Guardianship. This works very much like a custodianship, except for two things: It costs money to set up and administer, and there must be a court-approved guardian designated to oversee the investment. An advantage is that if the parents pass on before the end of the guardianship, the assets of the college fund are not counted in the estate, where they can be hit with estate taxes. Here again, however, the guardianship must terminate when the child reaches majority and the principal and interest belong to him or her.
* Clifford Trusts. This may be one answer for people mourning the loss of interest-free loans and looking for a similar alternative. Like an interest-free loan, the principal in a Clifford Trust is eventually returned to the parents, whereas the interest was used to pay college bills.
The last contribution to the Clifford Trust must be made at least 10 years and a day before withdrawals begin, so it should be completed either when the child is about 7 or 8 - or later, if there are plans for graduate school.
To be feasible, the Clifford Trust should have enough money in it to generate sufficient interest payments to meet college bills. While many parents may not be able to afford this large a sum, grandparents might be able to swing it.
A variation of the Clifford Trust has been introduced by Citibank, called University Trust. It has a starting level of $10,000, a much lower sum than many trust arrangements. Also, no lawyer is needed to start it, and the money is managed in a pool of three investment funds. Like the other options, income is taxed to the child, at the child's rate, which is usually lower.
As with a Clifford Trust, the University Trust must be in effect for at least 10 years, but interest from it can be used at any time to meet college expenses, says Diana Smith, a Citibank vice-president.
* Annuities. Parents or grandparents can open a variable annuity, naming themselves as owner and the child as annuitant. Payments can be made into the annuity at any time, and the interest is free of taxes as long as the annuity comes from an insurance company or one of its subsidiaries.
''As long as the money remains in the annuity and continues to be invested, it grows on a total tax-deferred basis,'' said Scott Logan, senior vice-president at Massachusetts Financial Services, a Boston-based mutual fund and a division of Sun Life Assurance Company of Canada. ''The annuity is a very sound vehicle for meeting future commitments like college expenses. But it's not the be-all and end-all. There are some drawbacks.''
Among the drawbacks, Mr. Logan said, is that when withdrawals are made, this money is taxed to the parents at their rate. A ''way around this,'' Logan points out, is to have the payments annuitized, or spread out, over a five-year period. Then, the parents can make an annual gift of the payments to the child.
If the annuity is started by grandparents, they may be able to make a larger initial contribution. Like anyone else who opens an annuity, however, grandparents should name a successor owner to take over in case they pass on before the end of the contract.
Or, if the parents or grandparents are concerned about having the annuity being counted as part of their estate, they can name the child as owner and place it in something like a UGMA account.