Cast Off Those Bonds of Oppression

The Bureau of Public Debt estimates that 55 million Americans have more than $196 billion in savings bonds, with billions more added each year. Much of this money is earmarked for educational expenses. Indeed, a survey released late last year by Aegon Institutional Markets showed respondents saving for college were almost 10 times more likely to use savings bonds for this purpose than 529 accounts.

The Bureau of Public Debt estimates that 55 million Americans have more than $196 billion in savings bonds, with billions more added each year. Much of this money is earmarked for educational expenses. Indeed, a survey released late last year by Aegon Institutional Markets showed respondents saving for college were almost 10 times more likely to use savings bonds for this purpose than 529 accounts.

Using series EE and series I bonds for education expenses seems smart on several levels. Low minimums, rock-solid government guarantees and the exemption of interest from state and local taxes are just a few of their positives. Plus, if the bonds were purchased after 1989, and the money is used for qualified higher education expenses, parents at certain income levels can avoid federal taxation on the interest as well.

But 529 plans, despite the shellacking they have taken in the bear market, have several advantages over traditional savings bonds, and the advisor who can sell clients on these is well on his way to creating a new stream of revenue.

One distinct drawback of savings bonds as an educational savings vehicle is that their interest is exempted from federal taxation only for parents with incomes below a limit ($86,400 filing jointly for 2002, $57,600 if filing a single return). Although these figures adjust upward for inflation, the cutoffs are still mighty limiting, since the income is checked when the bonds are redeemed, not when they are purchased.

To make matters worse, if parents cash in bonds for college but don't qualify for the exclusion, the total accrued interest could be added to adjusted gross income in the year of redemption. It would then be taxed at the parents' maximum rate, while simultaneously reducing the financial aid package offered by the school.

Some parents try to avoid such problems by placing the bonds in their kids' names. This maneuver helps the parents reduce their tax burden, because even though the bonds don't qualify for the education break, they are unlikely to generate enough annual interest to exceed the “kiddie tax” limits. However, bonds owned by the child share one negative consequence with Uniform Gift to Minors (UGMA) and Uniform Transfer to Minors (UTMA) accounts: Upon reaching adulthood, the child can do whatever he wants with the money. If, by some miracle, he puts the funds toward college costs, a school's financial aid office can count up to 35 percent of the proceeds in the Expected Family Contribution calculation.

One place where savings bonds scores recent points over 529 plans is in rate of return. Bonds have outpaced most equity-based plans in the last three years. But there are two reasons this is not a significant argument in their favor. First, the disparity in returns is more a function of a historically horrendous equities market since 529s debuted than of any innate advantage of bonds. Over time, 529 plans should easily outperform the savings bonds.

Second, over time investors will pay for the security of those bond investments in the form of interest rates that are not likely to keep up with rising tuition costs. According to nonprofit group The College Board, in the 12 months ending in October 2002, tuition and fees rose an average of 5.8 percent for four-year private colleges, and 9.6 percent for four-year public schools. Current savings bonds yield between three and four percent per year.

By highlighting these shortcomings of savings bonds, an advisor should be able to convince clients to convert some of their bond investments into 529 plans. Such plans would have the dual benefit of making money for the advisor, while simultaneously improving the lot of the client.

Writer's BIO:
Kevin McKinley
is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com

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