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Coverdell and 529 plans are good bets for some, but if you think your child may opt not to go to college — or you just want more control over your investments — you may want to consider education bonds.

EE bonds and Series I bonds are both part of the Education Bond Program created by the Treasury Department in 1990.

These are investments that may not make you rich, but that aren’t risky.

A benefit of this program over the 529 plans is that with these investments you won’t have to pay a penalty if you decide not to use them for your child’s (or your own) education. But if you do use them to pay for school, you won’t be required to pay federal income tax on the interest you earn. You can buy the bonds in denominations from $50 to $10,000.

At a glance
Bonds Custodial accounts
  • EE or Series I
  • Least-risky investment
  • No penalty if not used for education
  • No tax on earnings used for education
  • Must meet income guidelines to get tax exclusion
  • Must be 24 years old to purchase bonds
  • Money can be used only for tuition and fees
  • Must use money in the year bonds are redeemed
  • Taxes due if you redeem more money than you spend
  • Uniform Transfer to Minors Act (UTMAs) and Uniform Gift to Minors Act (UGMAs) accounts
  • No limit on annual contributions
  • Up to $750 per year in tax-free earnings
  • Custodian controls investment
  • Asset of the minor; can affect financial-aid eligibility
  • Can’t transfer money to another family member
  • Becomes asset of child at 18; doesn’t have to use money for education

EE bonds earn 90 percent of the average yield of the five-year Treasury securities. Rates are adjusted twice a year. I bonds are inflation-indexed bonds with yields pegged to the inflation rate. You can learn more about these bonds online at Savingsbonds.gov.

The bonds come with their share of caveats, so be sure you meet the requirements before you make a purchase.

Income

To qualify for the tax exclusion, you must meet certain income guidelines when you redeem the bonds.

For the 2004 tax year, for example, a single taxpayer’s modified adjusted gross income had to be less than $59,850 to take full advantage of the exclusion. The exclusion began to be reduced at that point, and was eliminated for adjusted gross incomes of $74,850 and above. For married taxpayers filing jointly, those two numbers were $89,750 and $119,750, respectively.

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The good news is that those numbers are adjusted annually, so the ceilings may be much higher when you redeem your bonds.

Keep in mind that your adjusted gross income for the year you redeem your bonds includes all the interest earned on the bonds you cashed in. Ironically, this may actually push some families past the cut-offs, reducing or even eliminating their exclusion.

Age

You must be at least 24 years old to buy the bonds. In other words, you can’t have a child and then buy the bonds in the child’s name to circumvent the income limitations listed above. You can use them yourself if you wish, but you still must be at least 24 when you purchase them.

Qualifications

You can use the expenses for tuition and fees, but not for room and board or books. Qualified expenses must also take into account any scholarships, fellowships or other forms of tuition reduction and you must incur the expenses the same year you redeem the bonds.

If you redeem more cash in bonds than you use for educational expenses, the interest you earn will be taxed on a pro-rated basis.

For example, if you have a $10,000 bond consisting of $8,000 principal and $2000 interest, and have $6,000 in expenses, you could exclude 60 percent of the earned interest, or $1,200. The other $800 would be subject to taxes.

Long-term plans

Cash in the bonds within five years of purchase and you’ll have to forfeit three months’ worth of interest, so make sure you won’t need to pull out the money for an emergency.

Custodial Accounts

If your family expects to pay for your college education or if your income is too high to receive any financial aid, you may want to consider a custodial account. Also known as Uniform Transfer to Minors Act (UTMA) accounts or Uniform Gifts to Minors Act (UGMA) accounts, they offer maximum flexibility and up to $750 a year in tax-free earnings.

There’s a significant drawback, however: Even though the parent is the custodian of the account, UTMAs and UGMAs are considered income-producing assets of the minor and therefore can significantly impact any aid you might apply for later on. Plus, your child will take over the account at age 18 and because there’s no requirement that the money be used for educational purposes the child can spend the money on anything.

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