As a parent, helping to pay for your child's college education may be one of the largest financial investments you'll ever make. For the 2020-2021 academic year, the average annual tuition, fees, room and board, and other expenses for undergraduate students ranged from $18,830 at public, two-year colleges and universities to $55,800 at private universities.
Meanwhile, most parents don't have much saved for their children's college. A 529 college savings plan can help you make up lost savings ground while enjoying some tax advantages. However, it's not the only way to save for future education expenses.
One alternative is using a savings bond for college planning. Savings bonds can offer predictable interest rates and stability, but they may not be right for every parent's (or student's) financial needs. If you're considering savings bonds for college, take time to weigh the pros and cons.
Benefits of Using Savings Bonds for College
There are two types of savings bonds for college planning: Series EE and Series I bonds. Series EE bonds have a government-backed guarantee to double in value over their initial bond term. On the other hand, Series I bonds can offer a fixed rate of return that adjusts with inflation over time.
In short, the key benefit of using bonds for college is that they're stable, safe, and you can gauge how much interest income they'll generate for college costs. When you invest money in mutual funds through a 529 plan, those funds become exposed to market risk. Thus, mutual funds have the potential to yield higher earnings, but there's a greater possibility that you could lose money compared to investing in government-backed bonds.
Another advantage is that the earnings on bonds are usually tax-exempt if you're using them to pay for higher education expenses—a 529 plan would also offer tax-advantaged withdrawals. If you were to use mutual funds to generate money for college, any earnings would be subject to capital gains tax. If you planned for that and are financially able to deal with the taxes, then mutual funds can be a great way to fund your child's college expenses. If not, bonds and 529s with qualified education withdrawals won't increase the taxes you pay on the earnings.
Bonds also offer flexibility since you can purchase multiple bonds in varying amounts with different maturity dates. By using maturity dates that expire progressively, you can create a customized bond ladder that can help you plan the timing for college-related, tax-advantaged withdrawals.
Why Bonds May Not Be Ideal for College Planning
While bonds can offer safety and security, they lack the earning potential of other investments, such as mutual funds or target-date funds that you could find in a 529 plan or Coverdell ESA. From November 2021 through April 2022, the composite yield for Series I bonds is 7.12%.
That's a decent rate of return, but if you need the assets to be more liquid, you could park your money in an online savings account or certificate of deposit. A savings account or CD could be more accessible than a bond. With savings accounts, you can make up to six withdrawals per month without incurring a penalty.
With CDs, you can choose between maturity terms ranging from one month to 10 years. If necessary, you can withdraw from a CD ahead of the maturity date; however, you'll pay an early withdrawal penalty for doing so.
The tax benefits of savings bonds for college only extend so far, which is another downside to be aware of. If bonds are used for anything other than qualified education expenses, the interest earned would be taxable. The exclusion for tax on interest also phases out based on income, so if you're a higher earner, you may not realize any tax benefits by using savings bonds for college.
Consider Every College Savings Option
Savings bonds can be useful in planning for college expenses, but it may not be wise to put all your savings eggs in one basket. Instead, consider the other ways you have to save and pay for college expenses.
Each method of saving for your child's college has benefits and drawbacks. It helps to weigh each one against your financial circumstances, and your child's as well, to see which one (or ones) might be best.
That includes considering a combination of 529 plans, Coverdell accounts, online savings accounts, and CDs. While technically a retirement planning tool, a Roth IRA can also do double duty as a place to stash college savings on a tax-advantaged basis.
As you compare different savings vehicles, consider whether there are any limits on how much you can save. For instance, a Coverdell ESA limits your contribution to $2,000 per year until your child turns 18. After that, no new contributions are allowed. A 529 plan, on the other hand, lets you contribute up to the annual gift tax exclusion limit each year. For 2021, that's $15,000 per child per parent. In 2022, the amount is being raised to $16,000.
Also, consider the time frame you have for college planning. If your children are still infants, a savings bond with a longer maturity date could make sense. On the other hand, it wouldn't make much sense if the bond you bought for their education doesn't mature until after they've already enrolled in or graduated from college.
Finally, consider the tax benefits and potential tax drawbacks of different savings options. If you take money from a 529 plan for anything other than qualified education expenses, that withdrawal would be fully taxable. With a Coverdell ESA, you're required to withdraw all the money by the child's 30th birthday.