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Savings Bonds

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US Savings Bonds offer a low-risk and modest return investment for saving for your children's college education. Series EE Savings Bonds and Series I Savings Bonds offer special tax benefits when used for qualified education expenses.

Other instruments discussed include Treasury Inflation-Indexed Securities (TIPS) and Zero Coupon Bonds including STRIPS.

Savings bonds are very safe investments, since they are backed by the full faith and credit of the US government. Principal and earned interest are safe and cannot be lost due to market changes, because Savings Bonds are not marketable securities. Savings bonds are registered with the US Treasury Department, and can be replaced at no cost if lost, stolen or destroyed.

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Education Bond Program

The Education Bond Program makes the interest on certain savings bonds tax free when the bonds are redeemed to pay qualified higher education expenses or to roll over into a section 529 plan.

Eligible bonds include Series EE Bonds issued after December 31, 1989 and all Series I Bonds. Series HH bonds are not eligible. Bonds purchased before 1990 may not be exchanged for bonds issued later to make them eligible.

The bond owner must be at least 24 years old on the bond issue date (the first day of the month in which the bonds were purchased). Parents can purchase bonds for their children, but the bonds must be registered in the parents name. The child cannot be listed as a co-owner, but may be listed as a beneficiary. You can also purchase bonds for your own education, in which case the bonds must be registered in your name.

There is an annual purchase limit of $30,000 per owner for Series EE Bonds and $30,000 for Series I Bonds. A husband and wife purchasing bonds as co-owners may purchase up to $60,000 in bonds in a single year. The purchase limit for Series I Bonds isn't affected by purchases of Series EE Bonds and vice versa.

Qualified expenses include tuition and required fees at Title IV postsecondary educational institutions, including colleges, universities and vocational schools. Room and board and books are not included. Qualified expenses are reduced by the amount of any financial aid received in the same tax year, including the amount of other education tax breaks (Hope Scholarship, Lifetime Learning Credit, scholarships, Coverdell withdrawals, section 529 plan withdrawals, etc.). Qualified expenses do not include courses that are not required as part of a degree or certificate-granting program. The expense or rollover must occur in the same tax year in which the bonds are redeemed.

The bond proceeds may be used for your own education, your spouse's education, or the education of a dependent for whom you claim an exemption on your income tax return. (Grandparents who own education bonds can only claim an interest exclusion for their children or grandchildren if the child or grandchild is a dependent listed as an exemption on the grandparents' income tax return.) Parents who are married must file a joint income tax return to qualify for the interest tax exclusion.

The parents must keep detailed records on the educational expenses paid and the bonds used for education. For the bonds this information includes the serial number, face value, date issued, date redeemed and total proceeds. For the educational expenses this information includes the educational institution, the date paid and the amount of the qualified expenses.

IRS Form 8815 (Exclusion of Interest From Series EE US Savings Bonds Issued After 1989) is used to exclude the interest on your income tax return. You may also find IRS Form 8818 (Optional Form to Record Redemption of College Savings Bonds) helpful in keeping track of your redemptions.

If the full proceeds of the bond redemption are not used for qualified education expenses, the amount of excludable interest is reduced pro rata.

There are income phaseouts on the interest exclusion, based on the year in which you redeem the bonds, not the year you buy the bonds. For 2011, the income phaseouts are $70,100 to $85,100 for single filers and $105,100 to $135,100 for married taxpayers filing jointly. (There is a pro-rata reduction in the exclusion within the ranges.) The income limits are adjusted annually for inflation and rounded to the nearest $50. Income is defined to be modified adjusted gross income, which is the adjusted gross income including interest on US Savings Bonds, but taking into account the partial exclusion of certain retirement benefits, adjustments for contributions to retirement savings, and adjustments for limitations on passive activity losses and credits.

Interest is also exempt from state and local taxes.

If you accidentally purchased the bonds in your child's name, you may have them reissued in your name so long as the funds used to buy the bonds didn't belong to your children and were purchased after December 31, 1989.

Note that if the savings bonds are registered in the child's name they are not eligible for the education bond interest exclusion. However, the interest on the bonds will be taxed at the child's income tax rate, which may still offer some tax savings.

Series EE Savings Bonds

Series EE Savings Bonds are issued at 50% of face value, meaning that a $100 EE Bond costs $50. They are offered in 8 denominations, which include $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Each individual may purchase up to $30,000 face value ($15,000 issue price) of Series EE Savings Bonds per year.

The interest on Series EE Savings Bonds is calculated at 90% of the 6-month averages of the yields on 5-year Treasury Securities. Rates are announced every May 1 and November 1. Series EE Savings Bonds are guaranteed to reach their face value in 17 years. (If the bond has not doubled in value in 17 years, the Treasury Department makes a one-time adjustment to bring the bond up to face value. This means the bond has a minimum guaranteed rate of return, if you hold it for 17 years until original maturity, of 4.16%.)

Series EE Savings Bonds are accrual or appreciation-type securities, which means their redemption value increases periodically as interest is added to the security's principal. Interest accrues on such a bond and becomes part of the redemption value (principal + interest) which is paid when the bond is redeemed. Series EE Savings Bonds increase in value monthly (on the first of the month) and the interest is compounded semiannually (every 6 months).

Series EE Savings Bonds can be redeemed after the first 6 months. If you redeem the bonds during the first five years after the date of issue, there is an early redemption penalty that forfeits three months of interest. The bonds can continue to earn interest up to 30 years from the date of issue.

Savings bonds are exempt from state and local income tax. Federal income tax may be deferred until you redeem the bonds or the maturity date (30 years), whichever comes first, and may be exempt from federal income tax if used to pay qualified higher education expenses.

Savings bonds can be purchased through a Payroll Savings Plan if your employer participates. Alternately, you can buy them directly through the EasySaver Plan which lets you purchase bonds automatically through transfers from your checking or savings account. Savings bonds may also be purchased online at Savings Bonds Direct. Savings Bonds can also be purchased at most banks.

Series I Savings Bonds

Series I Savings Bonds protect the purchasing power of an investment and earn a guaranteed rate of return by combining a semiannual inflation rate adjustment with a fixed base rate of return.

Series I Savings Bonds are issued at full face value, meaning that a $100 I Bond costs $100. They are offered in 8 denominations, which include $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Each individual may purchase up to $30,000 face value ($30,000 issue price) of Series I Savings Bonds per year.

Series I Savings Bonds earn interest as a combination of a fixed rate of return and a semiannual inflation rate adjustment based on the Consumer Price Index for All Urban Consumers (CPI-U). In periods of deflation, if CPI-U is negative and greater in magnitude than the fixed rate, the redemption value of the bonds will remain unchanged until the combined earnings rate becomes greater than zero.

Series I Savings Bonds are an attractive component of a college savings plan because the inflation adjustment offers a hedge against inflation while the fixed rate of return ensures some additional return on your investment. Fixed rates and inflation adjustments on new bonds are announced every May 1 and November 1.

Series I Savings Bonds are accrual or appreciation-type securities, which means their redemption value increases periodically as interest is added to the security's principal. Interest accrues on such a bond and becomes part of the redemption value (principal + interest) which is paid when the bond is redeemed. Series I Savings Bonds generally increase in value monthly (on the first of the month) and the interest is compounded semiannually (every 6 months).

Series I Savings Bonds can be redeemed after the first 6 months. If you redeem the bonds during the first five years after the date of issue, there is an early redemption penalty that forfeits three months of interest. The bonds can continue to earn interest up to 30 years from the date of issue.

Savings bonds are exempt from state and local income tax. Federal income tax may be deferred until you redeem the bonds or the maturity date (30 years), whichever comes first, and may be exempt from federal income tax if used to pay qualified higher education expenses.

Savings bonds can be purchased through a Payroll Savings Plan if your employer participates. Alternately, you can buy them directly through the EasySaver Plan which lets you purchase bonds automatically through transfers from your checking or savings account. Savings bonds may also be purchased online at Savings Bonds Direct.

Albert Einstein appears on the $1,000 Series I Savings Bond.

US Treasury Inflation-Indexed Securities

The US Treasury also sells marketable Treasury Inflation-Index Securities (TIPS), which are similar to Series I Savings Bonds. However, TIPS do not have the special education tax treatment of Series I Savings Bonds. Accordingly, most families interested in inflation-adjusted investments will be better off purchasing Series I Savings Bonds instead.

Zero Coupon Bonds

Zero Coupon Bonds are fixed-rate, fixed-return investment instruments. They are sold at a discount off of the value at maturity, and are guaranteed to be redeemed for that value if held until maturity.

US Treasury Zero Coupon Bonds are known as STRIPS, which is an acronym for "Separate Trading of Registered Interest and Principal of Securities". The STRIPS program lets investors split Treasury notes and bonds into their interest and principal components and trade them as separate securities. When a Treasury note or bond is stripped, each interest payment and the principal payment becomes a separate zero-coupon security.

STRIPS are not issued or sold directly to investors. Instead, investors may purchase them through financial institutions and brokerages.

Interest must be reported as income in the year in which it is earned, even though it isn't received until maturity or the STRIPS are sold. STRIPS are more popular components of tax-deferred accounts (retirement accounts and 401(K) plans) and non-taxable accounts (pension funds) for this reason.

The market prices of STRIPS tend to fluctuate more than the prices of the fully constituted security of the same maturity, because a STRIP represents a payment on a specific date while the original security represented a series of payments.

If a STRIP is held until maturity, the investor will earn the difference between the purchase price and the redemption value as income. If the STRIP is sold before maturity, the investor may realize a gain or loss depending on the market price. This is because the market price is based on the amount of future earnings and the current prevailing interest rate. If interest rates have gone up, a smaller amount of principal is necessary to earn the same amount of earnings, and so the market price goes down, leading to a loss. On the other hand, if interest rates have gone down, the investor could sell at a gain.

Zero Coupon Bonds may be of interest for college savings because they effectively guaranteed a specific return on investment on a pre-determined date. They also offer a hedge against a souring economy, because their market value increases when interest rates go down. However, many parents will not be interested in them because of the tax treatment, the potential for principal risk and the difficulty in understanding the market price movements for such bonds. Only more sophisticated investors should consider using zero coupon bonds.

Warning about Marketable Bonds

Bonds that are sold on the open market, instead of being held until maturity, may be vulnerable to principal risk. This is especially true of longer-term bonds. Parents investing in bond funds or in mutual funds that include bonds (e.g., balanced funds, 100% fixed income, etc.) should carefully evaluate the average term of the bonds in the portfolio.

When interest rates go up, the value of a bond's principal goes down. This is because one needs to invest less money to buy a bond that generates the same amount of income. Certainly, if you hold the bond until maturity, you will recover the full principal. But most people who buy marketable bonds don't hold onto the bonds until maturity, but buy and sell them on the open market. This means that bonds are valued more for the income they produce than for their underlying value at maturity. Of course, the closer a bond is to maturity, the less impact changes in interest rates will have on its value.

So if you buy marketable bonds in a low interest rate environment, where interest rates are likely to increase, stick mainly to short-term bonds. (On the other hand, if interest rates are likely to drop, you can maximize your benefit by buying longer-term bonds.)

For More Information

For more information about using savings bonds as a college savings vehicle, please see the US Treasury's Saving Bonds for Education web site. Other bond-related US Treasury web pages include:

Questions about savings bonds may be sent to the Bureau of the Public Debt's savings bond operations office at SavBonds@bpd.treas.gov. Current rate information may be obtained by calling 1-800-4US-BOND (1-800-487-2663) or visiting www.savingsbonds.gov.

See also IRS Publication 550 (Investment Income and Expenses) and IRS Publication 970 (Tax Benefits for Higher Education).

 

 
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