Beginner's Guide to Series I and Series EE U.S. Savings Bonds

1
Overview of U.S. Savings Bonds as a College Savings Vehicle

Overview:

Savings Bonds are one of the oldest and easiest to understand investments offered by the U.S. Government. They are considered an “accrual” type investment, which means that their value increases over time.

Series EE Bonds are purchased at half of their maturity value, and slowly increase towards that amount. Series I Bonds are purchased in denominations of $50 to $10,000, and slowly grow in value according to prevailing interest rates.

The government, as an incentive to purchase Series EE and I bonds, allows the growth in value to be exempt from Federal and state taxation if cashed out and used to pay college expenses.

Ideal Investor:

Series EE and I bonds should be considered by individuals who meet some or all of the following criteria:

  • They prefer the safety and simplicity of Savings Bonds over the risk and complexity of other investments and account types.
  • They are satisfied with an annual rate of return in the range of 4-6%.
  • They are in the highest Federal and state income tax brackets.
  • They can only invest smaller amounts at irregular intervals.
  • They want to retain ownership of the asset until they decide to use it.

2
Advantages and Disadvantages of Using U.S. Savings Bonds for College Savings

Potential Advantages:

Purchasing US Savings Bonds (Series EE or I) is one of the simplest ways to set aside money for college. There is no need to open an account at a financial institution, complete complex paperwork, or research and manage investment options. Further, the future value of Savings Bonds, especially Series EE bonds, is very easy to estimate.

Savings Bonds are available in small denominations and can be purchased for as little as $25 at a time.

The interest on these bonds is fully exempt from Federal and state income taxes when used for qualified college expenses, which makes them competitive with higher paying, but taxable investments.

Potential Disadvantages:

The biggest disadvantage, which is generally the case with any increased level of safety and simplicity, is a lower rate of return. With a historical rate of return between 4-6% annually, successful stock market investments can easily outperform U.S. Savings Bonds by double.

Another disadvantage, is that the exemption from paying taxes on college expenses is more limited than some of the other college savings accounts. Series EE and I bonds are only exempt from taxation when used for tuition (not room, board, or books), and are available only for taxpayers whose income is less than certain amounts.

3
Investment Options and Tax Benefits for U.S. Savings Bonds

Investment Options:

Savings Bonds rates are announced every May and November 1st, and are calculated using a standard formula. Existing Series EE Bonds do not change their rates as new rates are announced. Series I Bonds do.

The rate for Series EE Bonds is 90% of the average rate for 5-year Treasury Notes over the last six months.

The rate for Series I Bonds is a combination of a pre-determined fixed rate of return and an adjustment for inflation over the prior six months.

Tax Benefits:

The primary tax benefit for holders of U.S. Savings Bonds is the exemption from paying income tax on the interest and growth in value, if used for qualifying tuition. By design, Series EE and I bonds are also tax-deferred each year until they are cashed out.

This exemption from income tax on the growth of these bonds makes them competitive with other higher paying, but taxable bonds, held outside other college accounts.

For example, assume a bond from a corporation is paying 5% annually, but is fully taxable at a Federal rate of 25% and a state rate of 5%. After taxes are paid each year, at a rate of 30%, that bond yields a net after-tax income of 3.5%.

If a U.S. Savings Bond is only earning 4%, but will never be taxed because it will be used for college tuition, it clearly outperforms the taxable bond.

To qualify for at least a partial exemption from taxation on the interest, the owner has to have an income under $78,100 if single, or $124,700 if married.

4
Eligible Expenses and Effect on Financial Aid for U.S. Savings Bonds

Eligible Expenses:

Series EE and I Savings Bonds may only receive the income tax exemption for amounts used to pay for tuition at Title IV colleges, universities, and vocational schools.

Room, board, and books are not covered under the exemption. Withdrawals for these amounts will be subject to normal income tax.

Effect on Federal Financial Aid Eligibility:

Series EE and I Savings Bonds are considered assets of the parents if owned solely in a parent’s name, as is required for the exemption from tax. In this case, 5.64% of the current value of these bonds is expected to be contributed towards college costs each year.

5
Contribution and Eligibility Rules for U.S. Savings Bonds

Eligibility:

While just about anyone can buy Savings Bonds, to be eligible for the interest exemption for college costs, the purchaser must be over age 24. In addition, Savings Bonds must be held in a parent’s name to qualify for the exemption.

Contribution Rules:

A maximum of $30,000 of each type of savings bonds can be purchased in any given year. This amount would apply to each spouse separately if married.

Contribution Deadline:

There is no deadline for purchasing U.S. Savings Bonds for college savings. However, calendar years are used for purposes of determining the total amount of bonds purchased, as well as for measuring income levels to determine if an exempt withdrawal can be made.

6
Withdrawal Rules and Treatment of Unused Funds for U.S. Savings Bonds

Withdrawal Rules:

There are no withdrawal rules besides a six-month minimum holding period from the time of purchase to redemption.

Treatment of Unused Funds:

Savings bonds can be left to grow for as long as the owner would like.

Continue Reading...