As two tax-sheltered college saving ideas fade, another moves up

Getting Uncle Sam to help pay the kids' college bills is getting harder and harder. With the interest-free loan all but eliminated and the Clifford trust becoming less attractive, tax advisers are scrounging around for other tax-sheltered saving ideas. For many years, people used interest-free, or Crown loans, to ease the tax bite on the college fund. In this arrangement, a higher-bracket taxpayer made a loan to a lower-bracket taxpayer (here, from parent to child). No interest was charged by the lender and the borrower invested the money, letting it earn interest or dividends at a lower rate than the parent could enjoy.

Well, it didn't take long for the Supreme Court and the Internal Revenue Service to catch on to this one. First, the high court ruled that the loan creates a gift equal to the income that could be earned. Then the IRS all but killed off interest-free loans by saying the lender must report imputed interest as taxable income, even though no cash was actually received.

Then there is, or maybe was, the Clifford trust. With this device, income-producing property, including cash, is put in a trust by a high-bracket taxpayer, with the interest payable and taxable to the lower-income taxpayer in the same family. The trust must be in effect for at least 10 years, when the property can go back to the grantor, or creator, of the trust.

One drawback to the Clifford trust is built in: You may not want to commit money to a trust for 10 years.

The other drawback is potentially more serious. The trust is only temporary, but as far as the IRS is concerned, it is a gift and subject to potential gift tax. This tax is based on the assumed value of the income to be received by the beneficiary. The IRS tells you what the assumed value is. This is where the problem comes in.

Instead of an assumed interest rate of 6 percent, it is now 10 percent, which means that the maximum contribution to the trust under the $10,000 annual gift exemption has been reduced for a 10-year trust from $45,000 to $32,000, making the Clifford trust that much less useful.

``We're not abandoning Clifford trusts, but they're on the back burner,'' says Gary Hart, a tax principal in the Chicago office of Arthur Young & Co., the accounting firm.

Moving to the front burner, particularly for parents of sufficient means, is something called the spousal remainder trust. The birthplace of this device can be found in 1981's Economic Recovery Tax Act. One of the provisions of the act allowed unlimited tax-free transfer of assets between spouses.

Like a Clifford trust, income from a spousal remainder trust is taxed at the beneficiary's lower rate. The important difference, however, is time. A spousal remainder trust can be set up for any length of time, as designated by the grantor of the trust. At the end of that time, the principal does not return to the original owner, but must be passed on to the spouse.

In the meantime, the income from the trust can be flowing into a custodial account set up for a minor, where it is taxed at the child's lower rate.

For example, a spousal remainder trust could be set up to provide enough after-tax income to pay for four years of college. In an example provided by Mr. Hart, the goal is to come up with $6,600 a year for college. If the parents are in the 50 percent marginal tax bracket and had the money in their name, they would have to have $110,000 invested at 12 percent to accomplish this.

However, if money is in a spousal remainder trust, you only need $63,000 to provide the same after-tax result. If the money is kept in the parent's name, the $110,000 earns $13,200. Pay half of that to the tax man and you have $6,600 left. In the trust, $63,000 earns $7,500, but with a tax bill of just $900, you still end up with $6,600.

Like any tax-saving technique, there are some pitfalls and cautions. First, remember this is an irrevocable arrangement. Once you give the money to your spouse you can't get it back or set up an arrangement at the beginning to return the funds to you. This requires both a sound marital relationship and good financial planning to be sure you can do without this money in the future.

Second, income from a spousal remainder trust can be used only to provide children with benefits you are not legally obligated to cover. This means you can't use it for clothing or food, but in most places, you can use it for private schools and college expenses.

We say most places, because, Mr. Hart notes, at least one state supreme court has said that meeting these expenses is a legal obligation for parents who have the means to do so.

``This is still an unanswered question,'' he says. ``The question of legal obligation is generally determined by state law.''

You can find out how your state views these things when you talk to your lawyer or tax accountant about setting up one of these trusts. You'll need either or both of them to do so anyway, so questions like this can be cleared up at that time.

If you would like a question considered for publication in this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given. References to investments are not an endorsement or recommendation by this newspaper.

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