(MONEY Magazine) – First the bad news. The challenge of building savings to pay for your children's education -- which was never easy -- will be even tougher after the revised tax law takes effect. Items: -- Unless you use home-equity loans (see the story on page 91), you will no longer be able to deduct the interest on money you borrow for college. -- Your son or daughter will have to pay tax on any scholarship money that doesn't go for tuition and fees. -- And your ability to cut taxes by shifting your savings to your child through gifts and trusts will be restricted severely. Some superb tax-advantaged ways to save will remain. But Bruce Scharf, a partner in the Circle Consulting Group, a financial planning firm in New York City, warns: ''Parents are going to have to be more creative now.'' Under the old law, you could transfer investments to your offspring through two principal means: Clifford trusts, in which assets are held in your child's name for 10 years before reverting to you, and custodial accounts established under the Uniform Gifts to Minors Act (UGMA), in which assets are owned by your child outright. In both cases, earnings on those assets were taxed at your child's rate, no matter what his age, rather than at your presumably higher rate, making it easier for you to build funds for school bills. No more. The not-so-pleasant details: Clifford trusts. Under the new law, all income from newly created Cliffords will be taxable to whoever sets up the trust, whether they be parents, relatives or friends. If you have already established a Clifford, its tax treatment will depend on when you did so. Income from trusts created before March 1, 1986 will be taxed at your rate until your child reaches age 14. Then his tax rate will apply. But if you set up the trust after that date, the income will be taxed at your rate even after your child hits 14. Best advice: You probably won't be able to dissolve an existing Clifford, so if yours beats the March 1 cutoff, load it with tax- deferred investments such as U.S. Savings Bonds. If it is newer than that, your best option is tax-exempt municipal bonds. Custodial accounts. You can still put as much as $10,000 a year ($20,000 if you give jointly with your spouse) in an UGMA account for each child. But only the first $1,000 of income from new and existing accounts will be taxed at your child's rate if he is under 14. On anything above that, your rate applies. Once your child turns 14, however, all the account's earnings will be taxed at his rate. Best advice: make as heavy use of UGMA accounts as you can, bearing in mind your child's age so that you can invest the money in ways to keep taxes low. For example, if your child is under 14 and his account now consists of income-oriented stocks, such as utility shares that have risen since you bought them, sell the stocks before the end of the year while the capital gains will still be taxed at your child's rate. Then reinvest the money in fast-growing companies. When your child reaches 14, you can sell the shares and any gain will be taxed at his rate. Put the proceeds in the safest high-yielding investment you can find, since the interest will no longer be taxed at your rate. Current examples of such investments include high-grade corporate bonds (currently yielding around 9.5%) and risk-free one-year Treasury bonds, paying 5.4%. You should avoid risky investments at this point because with college only a few years away, you may not have enough time to recoup losses. Another way to postpone taxes while you build savings in a young child's account is to buy supersafe Series EE U.S. Savings Bonds with maturities that fall after the child's 14th birthday. The bonds currently pay at least 7 1/2% annually if held for a minimum of five years. The interest won't be taxed until the bonds mature. An alternative tax-deferred investment is life insurance. The policy's cash value will increase over the years with no taxes due on the earnings until withdrawal. Eventually your child could borrow at low rates from the policy to pay school bills without owing any tax at all. For example, you might pay annual premiums of $5,100 for a $250,000 universal life policy that nets, at present, 7 1/4% a year. If current rates of return hold, after 18 years a child born this year would have up to $178,000 to borrow against for college at below prevailing bank rates. Don't overlook tax-exempt securities. Yields on them have been extraordinarily high lately, with 30-year municipals paying about 7 1/2%, compared with 7 1/4% for taxable Treasuries of similar maturities. Zero-coupon municipal bonds are especially well suited to college savings plans. They pay no interest. Instead you buy them at a deep discount from face value and receive the full amount when the bonds mature. Thus you can count on accumulating a specified sum of money by the time you need it. But make sure that any zeros you buy can't be redeemed before their maturity date by the issuer. Recently you could buy a 10-year, $1,000 zero municipal yielding 7% for $400.

One apparent loophole in the new rules on custodial accounts offers an unbeatable option if you can take advantage of it. Under the revised law as now written, all earnings on gifts made to children by grandparents, other relatives or even friends are taxed at the child's rate, no matter what his age. Such a benefactor can give as much as $10,000 a year tax-free to each of your children. But don't be hasty about transferring money to your folks or Aunt Nellie for them to deposit in your kids' college kitty. The IRS is expected to be on the lookout for such fancy footwork. Barry Salzberg, a partner in the accounting firm of Deloitte Haskins & Sells, advises: ''The two gifts, from parent to grandparent and grandparent to child, cannot be remotely simultaneous.'' If they are, you could have to pay the IRS the difference between the taxes owed at your rate and at your child's as well as interest and penalties. QUOTE: After reform, all earnings on gifts made to children by grandparents will be taxed at the child's rate.