Janae Barron's parents gave her two daughters each about $50 in Series EE U.S. savings bonds before they had reached kindergarten. That nudged her to start saving for their education.
Series EE savings bonds are issued by the U.S. government, which doesn't tax the bonds' interest if the money is used for education. The gift inspired Barron and her husband to open tax-advantaged 529 plan accounts for each child.
Barron's daughters earned $500 savings bonds years later by winning essay contests, bonds that would mature to $1,000 over 25 years. She and her husband debated what the girls would do with the bonds if they waited to use them. Barron thought a possibility was "maybe for graduate studies when they're older."
She then compared the annual interest earned on her daughter Morgan's savings bond with annual earnings on her 529 plan, a college investment account. She realized the interest earned in one year was less than what would have been earned if the money had been invested in her 529 plan at the time.
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Her family cashed in the savings bonds and deposited the funds. EE bonds earn interest every year, but reach their maximum value from all interest earned at maturity.
There isn't a penalty for cashing in a bond early if it's to pay for qualified education expenses such as college tuition or to deposit in a 529 plan, says Jimmy Williams, an Oklahoma-based certified public accountant and personal financial specialist.
Parents do have an option of investing in Series EE U.S. savings bonds as part of their college savings strategy, but whether it makes investment sense depends on their interest rate, which in turn depends on when the bonds were issued.
According to the Treasury Department's website, the rate for EE bonds bought between May 1, 2013 and October 31, 2013 is 0.2 percent. That's only $1 earned during the first year on a $500 bond.
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"Prior to the formation and popularity of 529 plans, savings bonds were an effective method of saving for college," Williams says. "The bonds were bought at deep discounts – usually 50 percent of face value – and would mature to face value."
"In the current market, these bonds yield a very low return compared with the options within 529 plans today," says Williams. He adds that none of his clients are purchasing these bonds for their children's education.
But EE U.S. Savings Bonds had much higher interest rates in the past. Families still in possession of these bonds will earn quite a bit of guaranteed interest. For instance, bonds issued in the six months after May 1, 2006 earned a 3.7 percent annual fixed interest rate.
There is an income exception to cashing out the bonds for education purposes tax-free. A couple filing a joint tax return with income of $139,250 or more would have to pay taxes on total interest earned.
With income between $109,250 and $139,250, they'd have to pay taxes on part of the interest earned, Williams says. And, a form must be filed with tax returns stating how the money was used.
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Even for older bonds that earned interest, parents have to pay close attention to the maturity date, generally 30 years. Parents who bought bonds for their young children a few years ago don't have to worry about the maturity date, since their children will likely cash in the funds before the 30 years have passed.
But parents with unused bonds of their own who want to cash them out to place in a 529 plan for their children or to pay a qualified education expense should think about the expiration dates.
"For example, if the bonds you possess are dated prior to May 31, 1983 the bonds are no longer earning interest," Williams says. He advises parents in this situation to cash out the funds and deposit the money in a 529 plan account, provided they meet the income criteria above.
"For us, savings bonds started the saving-for-college conversation," Barron says. "But the low interest rate of bonds made the 529 plan a better educational investment for the long term."