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Savings bonds vs. 529 plans for college finance

Dear College Money Guru,
Is it better to buy U.S. savings bonds than use 529 plans? Considering the growth on the bonds (not sure of the series, they're the ones you get for $25, but mature to $50), the return is 100 percent, whereas my money market and 529 accounts are not doing as well at all.
-- Maryanne

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Dear Maryanne,
U.S. savings bonds can be an excellent college savings vehicle for many families. They offer a competitive interest rate, the safety of being backed by the U.S. government and federal and state income-tax benefits. But other college-savings options, including 529 plans, have advantages, too. You'll have to weigh the pros and cons of each option, in light of your own objectives and risk tolerance, in making the appropriate investment decision.

The Series EE savings bond is sold at a price 50 percent below face value when issued in paper form. A Series EE bond purchased between now and April 30, 2006 will earn a fixed rate of interest of 3.2 percent for the life of the bond. The interest rate will reset on May 1, 2006 for bonds purchased on or after that date.

An even more attractive alternative as inflation ramps up is the Series I savings bond (also known as the I bond). The government determines the interest rate on an I bond by establishing a low fixed rate (currently 1 percent) and tacking on an inflation component as measured by recent increases in the Consumer Price Index. Because inflation spiked during the relevant measurement period in 2005, the interest rate on an I bond purchased today is up to 6.73 percent.

Obviously, 6.73 percent is a terrific interest rate and is well above what you can currently get with EE bonds and most other government securities, money market accounts and bank certificates of deposit. However, the interest rate on an I bond purchased this month (November 2005), will adjust on May 1, 2006 with a new inflation component. (The inflation component will change every six months. The fixed rate applies for the life of the bond, as long as 30 years.)

You must hold on to a Series EE or I savings bond for at least one year before cashing it in, and three months interest is forfeited if you redeem your savings bond within five years. The interest you receive when redeeming the bond is always state-tax free and sometimes federal-tax free. The federal exemption on a post-1989 bond requires that you purchase the bond in your name after turning age 24. The exemption also requires that you redeem the bond in a year in which your income is below a certain level and in which you, your spouse or your dependent, incur sufficiently qualified higher education expenses (including contributions to a 529 plan). The income phaseout for qualifying bonds redeemed in 2005 is $61,200 to $76,200 ($91,850 to $121,850 for joint filers).

Over any given time period, a savings bond will perform better than some 529 investments and worse than others. Unfortunately, I can't tell you which particular 529 investments are going to perform best. What I can tell you from our research, however, is that over the past 12 months many 529 plans performed much better than 6.73 percent. Whether that will continue depends on future market conditions and inflation trends. You may have to accept more market risk to capture high returns in a 529 plan, and for older children, especially, you will probably want to minimize your investment risk.

If you decide to go with some type of inflation bond for at least part of your college savings, consider investing in 529 plans that utilize another type of government bond: Treasury Inflation-Protected Securities, or TIPS. The principal of these securities adjusts with inflation, and interest is paid on the adjusted principal every six months at a stated rate. Like other types of market-traded bonds, the yields on TIPS will fluctuate from day to day as determined by general interest rates and other factors.

A small number of 529 plans offer a TIPS portfolio as a stand-alone option. The Ohio CollegeAdvantage 529 Plan is a low-cost example of such a plan. A larger number of plans, including most of the 529 plans managed by TIAA-CREF, invest a portion of their fixed-income portfolios in TIPS. The yields on TIPS are currently hovering around 2 percent before taking into account the principal inflation adjustments.

Remember that while inflation bonds keep up with general inflation, they do not necessarily keep up with tuition increases. In fact, annual college tuition increases have been averaging more than twice the rate of general inflation. If your goal is to find an investment that keeps you ahead of college costs, you may have to add equity exposure to your college savings.

For more information about U.S. savings bonds, including the purchase of electronic bonds, go to www.treasurydirect.gov.

Bankrate.com's corrections policy-- Posted: Nov. 14, 2005
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