3 Ways to Boost Savings for College

QUESTION: I have been saving a few hundred dollars a year for my two daughters’ college education. But since the cost of tuition and room and board at a good private college is already about $15,000 a year, I’ll never save enough this way. Can you recommend some better ways?--P.H.

ANSWER: There are at least three better ways. Which is best for you depends on how old your children are, what tax bracket you are in and how brave you are. As you might guess, the device that best combines the twin virtues of fast savings at the lowest expense to you also requires a healthy dose of chutzpah.

If your children are young, you might consider buying zero-coupon bonds, which give you a lot of future buying power for little out-of-pocket money. Currently, you can buy a $1,000 zero-coupon bond, yielding 12%, for about $118 if you can wait 18 years for the payoff. A zero maturing in 12 years will cost you more on the order of $237.

To reap even greater returns from zeros, buy them in the child’s name so that the interest is taxed at her low rate instead of your higher one.

For parents who didn’t have the foresight--or the money--to start squirreling away money for college when their children were toddlers, there is a second widely used device. Called a Clifford Trust, it is a way to shift taxable income from a parent’s high tax bracket to a child’s much lower one. The principal must remain in the trust for at least 10 years and a day, and the income that principal earns must be fully distributed to the children by the end of the term. The principal is then returned to the parents.

Say your daughters will each need $15,000 a year during their college years. (We’ll assume their college years are back-to-back rather than concurrent.) If each received that amount in interest payments each year, they would owe taxes of about $3,000 each. So, on a pretax basis, each daughter needs to receive an annual income of $18,000. At current interest rates, you could expect to get 12% annual interest, meaning your college-education pot needs to contain $150,000 if you expect to fully finance their education on the interest that principal earns.

Because the income is in trust for your children and not for your own use, it is taxed at your children’s tax rate instead of yours. Thus, it is likely that the annual tax would be on the order of $3,000 instead of the $9,000 tax you would pay if you’re in the 50% tax bracket.

Nice, you might say, but who has $150,000 to put in a trust for 10 years? That’s where the third device comes to the rescue. It is a Clifford Trust with a twist, or as its critics might describe it, a device whereby you lend yourself money and deduct the fictitious interest expense from your federal income tax bill.

Actually, it’s more complicated than that. First, you borrow the money from a bank or other institution, probably by taking a second mortgage on your house. (Obviously, the size of your trust fund will be largely determined by the amount of collateral you have for the loan.) Next, you set up a trust and contribute your borrowings to it. (To be safe, hire an independent trustee, such as a lawyer or accountant. The fees charged by most banks and other financial institutions are usually prohibitive.)

Because it would be unseemly to fund the trust one day and borrow against it the next, leave the money untouched for a few months. Los Angeles attorney L. Andrew Gifford, of the firm McKenna, Conner & Cuneo and a specialist in this field, recommends a waiting period of at least three months. Then, borrow the money back from the trust and pay off the bank loan.

Now, your repayment obligation is to the trust--not to the bank. The loan should be adequately secured--perhaps by your house, which was freed of the second trust deed when you paid off the bank loan--and the interest rate should be competitive with going market rates and in conformance with state usury laws. In California, the rate cannot exceed the greater of 10% or 5 percentage points above the Federal Reserve Board advance rate. Currently, 13% is the highest rate that the trust could charge. It is in the parents’ best interest to have the rate as high as legally possible.

The trust enables you to save two ways: You get to write off your interest expenses on the loan from the trust, and your taxes are lower because the trust money is taxed at your children’s rate instead of your higher one.

In our example, here’s how you fare. Your obligation is $15,000 a year. If it comes from your income and you are in the 50% tax bracket, you would need $30,000 a year to come up with $15,000 after taxes. With the trust, your out-of-pocket cost is $12,000--that is $9,000 in interest expenses (in the 50% tax bracket, you’ll get half of your $18,000 expense back) and $3,000 for your child’s tax bill.

The income can be accumulated in the trust until your child needs it for college or private secondary school. However, all of the income must be distributed by the time the trust terminates. A trust like this will result in some gift taxes that will reduce your lifetime credit against federal gift taxes, which currently is $121,800 per taxpayer. Only the beneficiaries of the trust have the right to the income.

As you might imagine, the IRS isn’t wild about this device. So, if you are squeamish about the prospects of an audit, steer clear. Taxpayers who have used them successfully are those who have followed the technical rules to the letter, heeding the tax planner’s “big pig” theory: Pigs get fat; hogs get slaughtered.

Most important, be sure you don’t use any of the trust money to meet your child-support obligations. What constitutes support varies from state to state, so be sure you discuss this matter with the accountant or lawyer you choose to oversee the trust. In California, attorney Gifford considers such expenses as food, clothes and school uniforms and orthodontia work for children under 18 as parental obligations that can’t be reimbursed by the trust. Conversely, he considers private school tuition, summer camp, automobiles and music lessons as “arguably” legitimate trust expenses.

Make sure, too, that the trustee keeps good records and makes the applications to colleges, signs the checks for the expenses and files the tax returns. If the parents do those things, they will lose the benefits of the trust.

Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business section, The Times, Times Mirror Square, Los Angeles 90053.