Imagine an ultra safe tax-free college savings investment with no costs or fees that is guaranteed to beat inflation no matter how high inflation goes. It’s not too good to be true! It’s called an I-Bond or more technically a “Series I Government Savings Bond” and should be a part of any college savings portfolio.
I-Bonds are unique because they accumulate interest as a combination of both a rate set at purchase and a floating rate based on inflation. The formula is fairly complicated (you can see details at http://www.treasurydirect.gov/indiv/products/prod_ibonds_glance.htm) but the important thing is an I-Bond guarantees you will make interest on your savings above and beyond inflation. I-Bond’s inflation protection, low cost, tax benefits, and full control over your savings make them an extremely attractive way to save for college compared to typical options like 529 Plans, Educational IRAs, Gift to Minor Accounts, and even standard Savings Bonds.
- Fees and Investment Limits
Most of the common types of college savings plans are built with load mutual funds that carry high upfront fees and yearly expenses. There are NO fees to buy Savings Bonds since you are buying directly from the government. There is no red tape, no contract to sign, or hours spent on hold to talk to customer service. Investing in Savings Bonds can be as easy as an automatic deduction from your bank account every month.
You can buy in increments as small as $25; up to a maximum total of $5000 a year per social security number (Bank CDs normally have a $1000 minimum). A married couple with a child can buy up to $15,000 a year in Saving Bonds, with $5000 in the name of each parent and $5000 in the name of the child. In order to get the most tax benefits and flexibility and you’ll want to buy I-Bonds in your name first.
I-Bonds are US Government Bonds (safest investment class in the world) with the bonus of being protected against inflation, making them even safer. Your money is backed by a government guarantee for a real return above the increase of prices represented by the CPI (Consumer Price Index). Volatile economic times like early 2008 with soaring commodity prices and a falling dollar are a good reminder of the risk of inflation and the value of inflation protection. Because of this inflation protection, giving an I-Bond as a gift to a young relative instead of a standard Saving Bond could easily end up working out much better.
Investing for college is a lot like investing close to retirement. Putting everything in stocks without a long term horizon is very risky. Most college savings options are too aggressive and have a very real possibility of losing money or purchasing power just as you need to pay tuition bills.
- Interest Rates and Liquidity
I-Bond interest compounds monthly and you can cash it in at any time after a year (with a three month interest penalty) and after five years with no penalty. Savings Bond rates are usually lower than the bank CD market but are still competitive. Because rates are set twice a year you can wait until right before the new rate are set to buy. If interest rates have declined and/or inflation has been higher since the last rate was set, you will want to lock in the previous higher rate before the new rates become effective.
When you cash in your I-Bond do it as soon as possible after the monthly interest is paid because you get nothing for only part of a month. Remember to redeem the bonds with the lowest interest rates first to maximize your overall returns.
I-Bonds grow tax-deferred (like an IRA) and you never owe state or local income tax on them. If you use them to pay for college tuition for yourself, your spouse, or your dependents you won’t owe federal taxes (with some income limitations). Cashing in a savings bond and putting it all in a Coverdell Education IRA also counts as paying for tuition; say in the event interest rates go up and one of your savings bonds is no longer competitive. One counter-intuitive wrinkle is Savings Bonds are not federal tax free when cashed in if they are registered directly in a child’s name. This means the first savings bonds you buy every year should be in the parent’s names and then in the child’s name.
Many college savings plans require you to use the money only to pay for college (529 Plans or Education IRAs) or face a 10% penalty to withdraw the money for other uses. In many states full control of Gift to Minor accounts passes to the child when they turn 18. For most families it’s not too far fetched to imagine junior blowing his college savings bankrolling his beach bum lifestyle in Hawaii. If you buy a savings bond in your name (with your child or spouse as beneficiary) you retain full control over the money. This kind of benefit can not be overstated in case of a financial emergency or if you end up not having to pay for college after all.
I-Bond’s tax friendly, low cost, government backed inflation protection is an essential part of any conservative college savings plan.
You can learn more and buy I-Bonds online at the U.S. Treasury’s Website: http://www.treasurydirect.gov