THIS YEAR families trying to figure out how to pay for college expenses may find some unexpected flies in the ointment. Two new laws, the Tax Reform Act of 1986 and the Higher Education Act Amendments of 1986, have made sweeping changes not only in how students and their parents save, borrow, and pay for educational expenses, but also in how the federal government distributes student loans and other financial aid.

As a result, now may be the right time for families with college-bound children to reassess how they've planned to meet future educational expenses. Families with children already enrolled in college, on the other hand, face a considerably more complicated -- and urgent -- challenge: figuring out what to do when the rules suddenly change in the middle of the game.

No matter how much they earn, or expect to earn, parents generally realize that cash flow isn't the best way to cover college costs. Moreover, many of them simply don't have the earning power or financial resources to make the pay-as-you-go method possible.

That leaves several options for meeting educational expenses: saving, borrowing, liquidating assets, or some combination thereof. Because saving is typically viewed as the most attractive of these alternatives, increasing numbers of parents have sought to put college money aside in ways that maximize the return on their investment and minimize any adverse tax consequences.

Over the years, professional financial planners have responded by pitching a dizzying array of investment products to parents with college-bound children, especially those in middle- to upper-income brackets. Among them: Uniform Gifts to Minors, Clifford trusts, spousal remainder trusts, Crown loans, custodial accounts, zero-coupon bonds, tax-sheltered annuities, certificates of deposit, central assets accounts, and a variety of investment-oriented life insurance policies. A good number of these products represented variations on the same scheme: shifting the parents' income or assets to their children, who nearly always were in lower tax brackets.

Now, however, the tax advantages of many of these income- and asset-shifting maneuvers have gone out the window. The Tax Reform Act of 1986 established three distinct classes of income for children under 14 years of age; under the new law, only a child's earned income escapes taxation at the parents' marginal or maximum rates.

For many families with college-bound children, this part of the new tax law actually may be a blessing in disguise. In the past, parents who shifted income or assets to a child's name for tax purposes frequently discovered, after applying for financial aid, that the technique had backfired. The parents, often acting on the advice of an accountant or financial planner, had saved hundreds of dollars in income taxes but lost thousands of dollars in financial aid eligibility. The college's financial aid office, they found, would expect 35 percent of the student's assets to go toward educational expenses each year; if the money had stayed in the parents' account, however, no more than 5 percent of it would have been tapped each year. Why the difference? The standard financial aid formula has a built-in "asset protection allowance" for parents.

The lesson? Most parents should consider both the tax and financial-aid implications of various investment, savings and borrowing plans. The current financial aid formula, for example, counts as assets such investments as trust funds, certificates of deposit, mutual funds, money-market accounts, stocks and bonds, commodities, precious metals and so forth. It does not, however, consider the cash value of a life insurance policy to be an asset, nor does it count the value of various retirement plans (pension funds, annuities, Individual Retirement Accounts (IRAs), Keogh accounts, and so forth). Similarly, the financial aid formula doesn't count as income any payments from deferred or tax-sheltered annuities or from "roll-over" pensions.

In all likelihood, the Tax Reform Act of 1986 also will lead to massive shifts in how families borrow money to meet college costs. The new law has wiped out federal tax deductions for interest payments on all forms of personal and consumer debt -- except mortgages on a family's first and second homes. "When you really think about any kinds of loans for education, the interest is no longer deductible unless they are tied into home equity," says Joseph Re, executive vice president of Octameron Associates, an Alexandria-based educational consulting and publishing firm. "And that may have a big effect on people's thinking."

As a consequence, home-equity loans and lines of credit have become the first resort for families that need to borrow to meet educational expenses. And for many well-to-do families, borrowing against home equity is the only way to render educational expenses at least partially tax-deductible.

Home-equity loans and lines of credit can offer another important advantage to many families applying for financial aid, especially those living in areas with inflated real-estate values. Drawing down home-equity simultaneously reduces a family's asset base in the financial aid formula. Because the formula tends to discriminate against families living in or near high-cost areas like Washington, D.C. -- it ignores not only regional variations in real-estate values, but also regional cost-of-living differences -- many such families find that reducing home equity represents their only realistic hope of qualifying for financial aid.

Finally, it's important for families to realize that any financial aid dollars they receive are "leveraged." The higher a family's tax bracket, in fact, the greater the real value of any financial aid it receives. Because a family in a 50-percent tax bracket must earn $10,000 to have $5,000 left after taxes for educational expenses, for example, every dollar it receives in financial aid is really worth twice as much.

Education Amendments

AS IF tax reform hasn't given families with college-bound children enough to worry about, Congress, in passing the Higher Education Act Amendments of 1986, also has substantially rewritten the book on federal financial aid to students. The new rules, which become effective with the 1987-88 school year, fall into four broad areas:

Guaranteed Student Loans. In the past, a student was automatically eligible for federally guaranteed student loans if his or her family's adjusted gross income was $30,000 or less. A student whose family's adjusted gross income fell between $30,000 and $75,000 could qualify for the loans under a special formula that took several factors into account: family income (but not assets) and size, the number of children in college at the same time, and educational expenses.

No more. Beginning this year, all applicants for guaranteed student loans must demonstrate financial need to qualify, and family assets now are part of the eligibility equation. As a result, many students from moderate-income but "asset-rich" families may no longer qualify.

The new law also raises the annual and cumulative borrowing limits under the GSL program, as well as the applicable interest rates (see the accompanying chart). Students in graduate and professional schools are the big winners: they now can borrow up to $54,750 in guaranteed student loans (including those from their undergraduate years) -- more than double the former ceiling of $25,000. The GSL interest rate has been maintained at 8 percent only for the first four years of repayment; after that, it jumps to 10 percent.

National Direct Student Loans. The federal government provides 90 percent of the money for these loans, which colleges and universities dispense as financial aid to students with demonstrated need. They've been renamed "Perkins Loans" after the late Rep. Carl D. Perkins (D-Ky.), who for many years chaired the House Education and Labor Committee. Eligible undergraduate students now can borrow up to $9,000 over four years (compared to the previous ceiling of $6,000), and must begin repaying the loans nine months (rather than six months) after they leave school, graduate, or drop below half-time status. The interest rate remains at 5 percent.

(One note of caution: The Department of Education penalizes schools with high NDSL/Perkins default rates; as a result, they may have little or no federally supplied capital in their revolving funds for new loans. It pays to check in advance.)

College Work-Study. Last year, more than 870,000 students with demonstrated financial need were provided part-time, minimum-wage- or-above jobs through College Work-Study, a federal program that pays up to 80 percent of their earnings. Nearly 90 percent of those students were employed by their colleges or universities, with the rest working off-campus for nonprofit agencies or organizations. Beginning this year, however, for-profit companies also may participate in the program. That should mean an expanded array of employment opportunities for students who receive financial aid.

Independent Students. The Higher Education Act Amendments of 1986 have radically changed the definition of "independent-student" status, thus tightening a gaping loophole in the financial-aid system that many families had been exploiting. From now on, it's going to be a lot tougher for undergraduate students who apply for financial aid to successfully declare themselves independent of their parents. On the other hand, though, many graduate and professional students will more easily be able to qualify as independent.

If a student who applies for financial aid is judged to be "dependent," his or her parents must list their incomes and assets, along with other information, on the application form; all of the family's resources then are considered in calculating financial need. If a student is judged to be "independent," however, only his or her resources are used to assess need. Because most students are considerably less well-off than their parents, independent status can mean thousands of dollars in additional financial aid.

Beginning with this academic year, the federal government has introduced a minimum-age requirement for independent status. Students under the age of 24 are automatically considered dependent unless they fall into at least one of several narrowly defined categories. The exceptions include orphans, wards of the court, and veterans; unmarried students with legal dependents; and married, graduate, or professional students who are not claimed by their parents as dependents for income-tax purposes in any calendar year during which they receive financial aid. Students under the age of 24 also may establish independent status by certifying that they were not claimed as tax dependents in the two years preceding their receipt of financial aid and demonstrating their self-sufficiency during that period. (An unmarried undergraduate student, for example, must show evidence of earning at least $4,000 a year.)

Because no "grandfather" provision was written into the law, many undergraduates who previously qualified as independent students no longer will be eligible for financial aid -- unless, of course, they can reestablish their eligibility as dependents.

Under the new rules, all students 24 years of age or older are automatically considered "independent" unless they indicate that their parents intend to claim them as dependents for income-tax purposes in the upcoming year. As a consequence, many of these students will, for the first time, be able to qualify for loans and other forms of financial aid. They should enjoy their new-found eligibility while it lasts: Congress, oddly enough, didn't clearly envision this situation when it amended the Higher Education Act last year.