Zero-coupon bonds as a college nest egg: beware tax erosion

If you're looking for new ways to save money for college expenses, beware the Phantom of the Zero. The ''zero'' is short for ''zero-coupon bond,'' one of the latest products being sold by brokerage houses for individual retirement accounts, Keoghs, and pension funds, as well as college savings plans.

The ''phantom'' comes with the saving-for-college strategy.

Most bonds make interest payments semiannually, either through redemption of a coupon attached to the bond or by a direct payment to the holder. With a zero-coupon bond, there are no - or, zero - coupons. Also, it is a deep-discount bond, where the difference between what you pay and the higher redemption value represents your return.

If you want $40,000 in 13 years, for example, you could buy a zero-coupon bond for $5,820 today. With an 11 percent return, you would have your $40,000 by 1997. So a parent or grandparent who wanted to help provide today's five-year-old with enough money for college when he or she was 18 could purchase a zero and put it in the child's name.

While each year's gain is taxable, the much lower tax bracket most children are in means they would pay little, if any, tax.

This, however, is where the ''phantom'' comes in, says William Freund, a vice-president and financial planner at Prescott, Ball & Turben Inc., a Cleveland brokerage. While the zero is generating income, it is not providing a way to pay the taxes on that income, a situation known as ''phantom income,'' Mr. Freund says.

''There is no income from a zero until maturity,'' he notes. ''But each year you get a tax bill, and the zero hasn't given you any cash flow to pay it.''

While four- or five-year olds are not likely to have enough income to put them in a tax-paying bracket, 16- or 17-year-olds might. Combined with other assets, investments, and pay from part- or full-time jobs, the income from the zero may be just enough to push the youngster into a higher bracket where he - or someone - would have to come up with additional money to pay the tax collector.

''When we buy that zero (for the five-year-old) we're being all too casual about what the tax liability of the 18-year-old is going to be,'' Freund says.

In the worst case, where there was not adequate income to pay the tax liability, the zero-coupon bond could be liquidated, or sold early, to pay the tax bill, he notes. But this assumes the bond market will be favorable enough at the time to let you sell the zero at or near its full value.

In the last year or so, several major brokerages have been selling a variation of the zero-coupon bond concept. These firms put together packages of US Treasury bonds, each with its own maturity; give them names like TIGRS (Treasury Investment Growth Receipts from Merrill Lynch & Co.) and CATS (Certificates of Accrual on Treasury Securities from Salomon Brothers); and sell them as zero-coupon, deep-discount bonds. One advantage for small investors is the low cost of participation, often less than $2,000.

Zeros, CATS, TIGRS, and the like are well suited to IRAs, Keoghs, and other savings plans that can earn tax-free interest until they are withdrawn, Mr. Freund says. But for college savings plans, he believes, they should play only a supporting role.

''They're not a bad thing for college; I have used them with some clients,'' he says. ''But they should be balanced with other things,'' some of which can generate the income to pay taxes. The other things might include a common stock mutual fund, money market funds, or municipal bonds.

While he realizes that many parents of young children may not have a spare $2 ,000 to $5,000 to purchase a zero, many of these parents have relatives who can spare the money.

''What I'm most concerned about is the grandfather who says, 'I'll help the grandkids with college by buying one of these big zeros,' '' Freund says. ''They should look at other alternatives.'' Alternatives might include outright gifts of cash (up to $10,000 a year per donee free of gift tax), ''gifting'' long- or short-term stock gains, interest-free loans (be careful with these, as the Internal Revenue Service is attacking them), and Clifford Trusts.

'Timing' stock purchases

Can you describe market timing for stock purchases and sales so non-professional investors can know how to use this technique to keep assets intact and growing? - O. L. If you follow the market closely and have an understanding of economic theory and technical analysis, it is possible to ''time'' investments so that you buy or sell to take advantage of changes in market conditions. Timing, however, is just a shade removed from speculation and should be treated cautiously. The stock market is highly erratic, and many speculators and timers are poorer for their supposed abilities. Numerous timed transactions can also erode gains through brokers' fees. But if it is not used as a way of ''playing the market,'' timing can help improve a transaction you had been considering anyway.