Published January 11, 2012
Dear Dr. Don,
I hope you can help me out with making the right decision. My wife and I, along with our children's grandparents, are looking to purchase savings bonds for the children instead of buying presents here and there. I am trying to find secure bonds and gain interest, and they can use them for college. Can you please direct me to the best option available for my children?
-- Alex Accumulate
I'm not wild about savings bonds as a savings vehicle for college expenses. The yields on Series EE bonds are low unless you hold the bonds for 20 years. Series EE savings bonds are required to double in value in 20 years, which mandates a minimum yield of about 3.53%. Unfortunately, current purchases earn only 0.6% up until year 20, at the time of writing. Depending on how old your children are, they could miss the bump up in yield, having graduated from college by then.
Current purchases of the Series I savings bond will earn the inflation rate as measured by the U.S. Consumer Price Index. The yield on the Series I bond is 3.06% at the time of writing. That yield will change every six months with changing inflation. College inflation has greatly outpaced the index, so Series I savings bonds only offer a partial hedge against rising tuition expense.
The education tax exclusion permits qualified taxpayers to exclude from their gross income all or part of the interest paid upon the redemption of eligible Series EE and I bonds issued after 1989, when the bond owner pays qualified higher education expenses at an eligible institution. The bonds have to be registered in the parent(s) name/names, the parents have to be at least 24 years old when the bonds are purchased, and the parents' income has to be below the then current income limits to take advantage of this exclusion.
Other than the education tax exclusion, it is possible to register the saving bonds in the children's names with the parents as beneficiaries and have the interest income either included in the child's income each year as it accrues or deferred until the bonds are redeemed. In either case, it's the child who will be subject to any federal income tax due on the interest earnings.
The tax benefit from having the tax income included each year in the child's income is that the child doesn't owe income tax until his or her income in a single year is at or above the standard deduction, currently $950 for unearned income. That's a lot of savings bond interest. However, any unearned income above a second threshold, currently $1,900, is taxed at the parent's marginal federal income tax rate. This "kiddie tax" threshold is for children younger than age 19 or for college students younger than age 24. Between $950 and $1,900 of unearned income is taxed at the child's rate. Interest income is considered unearned income because it isn't employment income.
I'd rather see you and the grandparents look to Section 529 plans as investment vehicles to save for college. Check out your home state's 529 plans first to see if your contributions generate a tax deduction. The more worried you are about college inflation, the more a prepaid tuition plan can make sense versus an investment account. There are conservative investments available in the investment accounts that can match your need for the protection of principal, but they may not be your best option if the children are young because the low yields won't keep pace with college cost inflation.