U.S. Savings Bonds can be tricky vehicles for college savings

by John Pearson

Personal Finance: Student Financial Aid

June 2006

As investments, savings bonds have never led the pack. They are a bastion of safety and security for the small saver, but the returns on Series EE bonds are stingy.

However, for college savings, Uncle Sam sweetens the pot. Some parents can earn the interest tax-free on EE and inflation adjusted Series I bonds if the proceeds are used to pay tuition and fees. Note I said parents. The bondholder must be at least age 24 on the day the bond is issued to get the exemption. And there are certain income limitations, which are specified in publication 970 at www.irs.gov.

But a parent would be making a mistake by not considering consider having the student own the bonds. Certainly, if the family will be out of the running for substantial need-based aid. And especially, if the student's annual investment income, including interest on the bonds, would be less than $800.

Annually, $800 in investment income can be excluded tax-free from a child's adjusted gross income. And a child can elect to claim the accrued interest annually on the bonds without cashing them in. So when the bonds are actually redeemed, nearly all the interest will have already been considered for taxation.

Maybe the bigger mistake is not considering more growth-oriented investments in the first place. Right now Series EE bonds are paying 3.7%, locked in for 20 years. Not exactly keeping up with education inflation, are they?
 

John Pearson is a CPA and certified college planning specialist. He can be reached at john@johnpearsoncpa.com.