Making college fund grow. Tax laws call for saving the old-fashioned way

Parents who have been trying to make sure their children will have enough money to go to college have been getting hit from all sides. Colleges continue to raise costs twice at a rate about twice that of inflation, student aid is shrinking, and the government has taken bites out of two tax breaks: the deductibility of student loans and the ability of parents to let college funds build up tax-free.

As a result, making a college fund grow is getting down to the basics of saving early and often and making effective investment decisions. Before making any decisions, however, parents are examining single-premium life insurance policies, zero coupon bonds, mutual funds, municipal bonds, United States Savings Bonds, and even some corporate and utility stocks.

Even though the tax laws have made it harder to save for college and save on taxes at the same time, there are still ways to do this - at least until some future Congress decides to clamp down on another tax break. One of the most popular survivors of tax reform is the single-premium life insurance policy.

``In terms of saving for college, single-premium life is probably best if a child is very young,'' says Stuyvesant Wainwright, vice-president in the emerging investor services division of Merrill Lynch & Co. These policies start with a lump-sum payment, usually from $5,000 to $20,000, and provide a pool of savings plus some life insurance. The interest rates vary, but they're currently running from about 7 to 9 percent.

There are two types of single-premium policies: variable life, in which you pick your own investments from a menu of options, and whole life, in which the company declares an interest rate that is changed once a year. With both types, but especially variable life, you can lose some of what you think is being earned on fees, although a few companies are now offering ``no load'' products.

When your child is ready for college, you can tap the policy by taking out a policy loan and still not pay any taxes.

``There's one drawback to this, though,'' says Jack Connolly, assistant vice-president for personal financial services at Dean Witter Reynolds Inc. ``There's generally a 1 percent interest charge on any money withdrawn.'' This can be kept to a minimum by taking out only what is needed for a short period of time, like one semester's school expenses.

Another investment getting more attention because of tax reform is the zero coupon bond, especially ``muni zeros'' issued by states, cities, and other government authorities.

``You know what they're going to be worth when they mature,'' Mr. Connolly says. ``If you knew what college was going to cost 10 years from now, they'd be even better.''

Because parents don't know, however, they should not be putting all their college savings in zeros, whether they are the taxable or tax-free variety. But putting 20 to 40 percent of the college funds in zeros will help make sure that that portion grows at a predictable rate.

If the investment is in taxable zeros from corporations, for instance, and if the child is less than 14 years old, any internal profits of more than $1,000 a year will be taxed at the parent's rate. In some cases, that may not be a problem, because in the first few years the zeros could earn less than $1,000. Taxes at the parent's rate may only be assessed for the last two or three years before the 14th birthday.

The classic version of the zero coupon bond is, of course, the US Savings Bond. These are sold at 50 percent of face value, and you can buy several denominations, from a $50 bond purchased for $25, up to a $10,000 bond bought for $5,000. You can invest up to $15,000 ($30,000 face value) in Series EE bonds in the name of any one person each year. The date they mature depends on the interest rate, which until last year was 7.5 percent. Now the minimum is 6 percent. While the bonds do let you defer interest until the child is 14, you can probably get a better yield with other types of bonds.

If you do decide to move into stocks, most experts say, stick with well-known companies that have a long history of growth and dividends. And in this market, which is so high that many analysts think it's ready for a fall, you may want to keep the stock portion of the college portfolio down to no more than 25 or 30 percent.

``For years, people have done extremely well with long-term investments in equities,'' says Theodore Smith, senior vice-president and sales manager for income products at Shearson Lehman Brothers. ``Depending on the family, a portfolio of some equities along with some zeros might be warranted.''

``I'd stick to `blue chip' equities very closely,'' says Mr. Wainwright, suggesting companies like International Business Machines, General Electric, and General Motors. There are possible pitfalls here, too, he notes. Fifteen years ago, he recalls, he was in a meeting where the most-often recommended stocks were Standard Oil of California, BankAmerica, and IBM. Considering what's happened to Standard Oil and BankAmerica, he says, ``in hindsight, there are a lot of other things one could have done.''

If selecting and buying stocks directly is daunting, you can let a mutual fund manager pick them for you. While there are hundreds of mutual funds to choose from, you can save time - and some college funds - by sticking with no-load or low-load funds, where there are no sales charges or the charges are no more than 2 or 3 percent.

If anything, the changes in the tax laws are returning college nest egg-building back to the fundamentals. ``We're back to the old-fashioned idea of trying to put away money early on a fairly steady basis,'' Wainwright says.