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Pros, Cons of Paying for College With Savings Bonds

Deborah Ziff

Savings bonds were once the tool du jour for giving children a start on saving, including for college.

Now, 529 college savings plans are a more popular college savings investment tool -- and with good reason, say financial experts. They offer growth for college savings on a federal tax-free basis if used for what are known as qualified educational expenses -- tuition and books, for example -- and an array of investment options.

But U.S. savings bonds -- Series EE and Series I -- do offer some advantages for college savers: They are virtually risk-free and offer tax benefits for higher education if owners meet certain requirements. However, their meager rate of return is no match for the rapidly rising pace of college costs.

Today's savings bonds earn interest for 30 - year terms but , unlike the old paper bonds, must be purchased electronically on the Treasury Direct website, for as little as $25 but not to exceed $10,000 per year.

Here are pros and cons of including savings bonds in your plans to save for college.

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Pro: Savings bonds are safe. U.S. savings bonds are a government-guaranteed, safe, low-risk investment. With savings bonds, owners will have little fear of losing their principal investment.

Although many 529 plans offer low-risk portfolio options in the form of money market accounts or certificates of deposit, a parent could consider including savings bonds as an element of a college savings strategy, especially if he or she isn't satisfied by the 529 plan's conservative options, says Kevin McKinley, financial planner at Wisconsin-based McKinley Money LLC and host of "On Your Money, " a financial advice radio show.

"They may serve as an effective complement to investments in a 529 account that may have more potential risk and reward," he says.

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Con: Savings bonds offer low returns. Series EE bonds offer a fixed rate of return, while the rates of Series I bonds rise and fall with the U.S. Consumer Price Index.

The interest rate on a Series EE bond is a paltry 0.1 percent, meaning if you invest $100, you earn one penny each year. However, the Treasury guarantees that for an electronic EE bond with a June 2003 or later issue date, after 20 years, the redemption value will be at least twice the purchase price of the bond. That means a $10,000 bond bought today would be worth $20,000 if the owner held it until 2037, earning the equivalent of about 3.5 percent a year, McKinley says.

Series I bonds are made up of two rates, a fixed rate and an inflation rate. The current rate is 2.76 percent through April 30, according to the Treasury Direct website.

Of the two, McKinley says he recommends the Series I bonds, especially if savers think they will need the money before 20 years.

But many experts argue that college seekers should look for investment vehicles with potential for bigger gains to tackle the ever-increasing cost of college. Over the last 10 years, published in-state tuition and fees increased at an average rate of 3.5 percent beyond inflation, according to the College Board.

Ray Hawkins, a certified financial planner at AEPG Wealth Strategies in Warren, New Jersey, says he recommends 529s over savings bonds for college savings.

"Over a seven- or nine-year period, you should get rate of return of 5 percent at least," with 529 plans, he says, " v ersus what they're getting here."

However, if you purchased a savings bond in the 1980s or 1990s, when interest rates were more competitive, you may want to hang on to your savings bonds to full maturity.

"Let's say you bought in the '90s, there could be 7 or 8 percent interest on those things," Hawkins says. "You really wouldn't want to cash them out if you don't have to."

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Pro: They offer some tax advantages. Although you are usually required to pay tax on the interest earned on savings bonds, there is an exemption for higher education expenses. If you cash in the bonds under an education savings bond program, you may be able to exclude the interest from your income.

Con: Not everyone is eligible for tax advantages. There are income limitations to the favorable tax treatment. The amount of your interest exclusion is gradually phased out if your modified adjusted gross income is between $77,550 and $92,550 -- between $116,300 and $146,300 if jointly filing -- according to the IRS.

Also, the owner must be 24 years old before the issue date, meaning if the bond is in your child's name, he or she won't get the tax benefits. If you do decide to purchase a savings bond with the intent of using it for college, make sure to put it in a parent's name, McKinley says.

Finally, the education tax benefits only apply to Series I bonds and Series EE bonds issued after 1989.

If you are holding a savings bond that you purchased after 1989 and think you may exceed the income limitations, Hawkins suggests cashing it out and rolling it into a 529, where you could still get favorable tax treatment. You have 60 days to do so, but make sure you also fill out IRS form 8815 "to qualify you did not take money and run," Hawkins says.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

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