For many new parents and grandparents, finding a way to fund their children's and grandchildren's future education expenses is a primary concern. College costs have risen at an average annual rate of 8% over the past ten years, and today's parents can count on a hefty bill for their children's college education in the future. In fact, at this rate, it could cost as much as $80,000 for a four-year public college education 17 years from now! How can parents and grandparents help meet these future education costs? One way to generate funds for college expenses is to invest in a ladder portfolio of U.S. Treasury Strips Zero Coupon Bonds. Here's why.

U.S. Treasury Strips, commonly known as Fed Strips, are backed by the "full faith and credit" of the U.S. government-the highest level of credit quality available in a fixed-income investment. In addition to safety, Fed Strips also provide the buy-and-hold investor with a guaranteed rate of return. As with most Zero Coupon Bonds, Fed Strips are offered at a discount to their face value and pay no periodic interest over the life of the security. Instead, interest accumulates at the stated yield level, compounding toward full maturity value and eliminating reinvestment uncertainties. When Fed Strips are held to maturity, the difference between the discounted purchase price and their face value represents the return on investment.

Note: When Zero Coupon Bonds are purchased in taxable accounts, the accumulated interest, although not actually received until maturity, is subject to annual taxation as ordinary income. Also bear in mind that prior to maturity, the market value of Strips is, in general, significantly more volatile than interest-paying bonds.

Depending on the maturity of Fed Strips, the discounted purchase price can make this security very affordable. A Fed Strips maturing in 18 years can currently be purchased for a fraction of its $1,000 face value. What's more, Fed Strips are issued with February, May, August and November maturities of every year, extending out to 2021. This flexibility is appreciated by those investors looking to time the maturity of their bonds to coincide with their individual financial objectives. More important, the flexibility of this security makes it a good selection for ladder portfolios.

Building a ladder portfolio of Fed Strips is as easy as spreading the total dollar amount of your investment among a series of successive maturities. College planning investors can conveniently purchase a Fed Strips ladder with bonds scheduled to mature in August of each school year in the future when tuition payments are typically due. This method of investing provides an affordable, simple way to plan ahead.

Sample College Planning Ladder 
SCHOOL    YEAR   MATURITY MATURITY TODAY 
2011-2012 YEAR 1 08/15/11 $20,000  $6,011 
2012-2013 YEAR 2 08/15/12 $20,000  $5,565 
2013-2014 YEAR 3 08/15/13 $20,000  $5,125 
2014-2015 YEAR 4 08/15/14 $20,000  $4,773 
TOTALS:                   $80,000 $21,474

Assuming annual public college costs in seventeen years of $20,000, a four-year $80,000 college bill would cost only $21,474, if you invested toward these costs today through this hypothetical Fed Strips ladder portfolio. Note: Figures in this example are for illustrative purposes only and may not reflect current rates.

Consider Gifting a Ladder of Zero Coupons to a Child

A convenient way to enhance the returns of Zeros earmarked for college funding is to establish a ladder portfolio within a special custodial account that, depending on your state of residence, satisfies the requirements of either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).

When funds are deposited in an UGMA or UTMA account, they constitute an irrevocable gift to your child. Under current law, a single parent may annually gift up to $10,000 per child ($20,000 annually for a married couple) without gift tax consequences.

Income earned by a minor generally carries certain tax advantages, including the exclusion of federal taxes on the first $600 of unearned income. The second $600 is taxed at the child's rate. Earnings by a child in excess of $1,200 are taxed at the parents' rate until the child is 14 years old, after which all such income is taxed at the child's rate.

Investors should consult their tax advisors about current UGMA and UTMA gifting requirements and discuss their tax situation before making any tax-related investment decisions.

Gary Barker, an Account Executive at Dean Witter, specializes in portfolio management, retirement planning and asset allocation. He can be contacted at 800-755-5203.

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