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US Savings Bonds offer a low-risk and modest return investment for saving for your children’s college education. Series EE Savings Bonds and Series I Savings Bonds offer special tax benefits when used for qualified education expenses.

Other instruments discussed include Treasury Inflation-Indexed Securities (TIPS) and Zero Coupon Bonds including STRIPS.

Savings bonds are very safe investments since they are backed by the full faith and credit of the US government. Principal and earned interest are safe and cannot be lost due to market changes because Savings Bonds are not marketable securities. Savings bonds are registered with the US Treasury Department, and can be replaced at no cost if lost, stolen or destroyed.

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Education Bond Program

The Education Bond Program makes the interest on certain savings bonds tax free when the bonds are redeemed to pay qualified higher education expenses or to roll over into a section 529 plan. Eligible bonds include Series EE Bonds issued after December 31, 1989 and all Series I Bonds. Series HH bonds are not eligible. Bonds purchased before 1990 may not be exchanged for bonds issued later to make them eligible.

The bond owner must be at least 24 years old on the bond issue date (the first day of the month in which the bonds were purchased). Parents can purchase bonds for their children, but the bonds must be registered in the parents’ name. The child cannot be listed as a co-owner, but may be listed as a beneficiary. You can also purchase bonds for your own education, in which case the bonds must be registered in your name.

Qualified expenses include tuition and required fees at Title IV postsecondary educational institutions, including colleges, universities and vocational schools. Room and board and books are not included. Qualified expenses are reduced by the amount of any financial aid received in the same tax year, including the amount of other education tax breaks (Hope Scholarship, Lifetime Learning Credit, scholarships, Coverdell withdrawals, section 529 plan withdrawals, etc.). Qualified expenses do not include courses that are not required as part of a degree or certificate-granting program. The expense or rollover must occur in the same tax year in which the bonds are redeemed.

The bond proceeds may be used for your own education, your spouse’s education, or the education of a dependent for whom you claim an exemption on your income tax return. (Grandparents who own education bonds can only claim an interest exclusion for their children or grandchildren if the child or grandchild is a dependent listed as an exemption on the grandparents’ income tax return.) Parents who are married must file a joint income tax return to qualify for the interest tax exclusion.

Zero Coupon Bonds

Zero Coupon Bonds are fixed-rate, fixed-return investment instruments. They are sold at a discount off of the value at maturity, and are guaranteed to be redeemed for that value if held until maturity.

US Treasury Zero Coupon Bonds are known as STRIPS. which is an acronym for Separate Trading of Registered Interest and Principal of Securities. The STRIPS program lets investors split Treasury notes and bonds into their interest and principal components and trade them as separate securities. When a Treasury note or bond is stripped, each interest payment and the principal payment becomes a separate zero-coupon security.

STRIPS are not issued or sold directly to investors. Instead, investors may purchase them through financial institutions and brokerages.

Warning about Marketable Bonds

Bonds that are sold on the open market, instead of being held until maturity, may be vulnerable to principal risk. This is especially true of longer-term bonds. Parents investing in bond funds or in mutual funds that include bonds (e.g. balanced funds, 100% fixed income, etc.) should carefully evaluate the average term of the bonds in the portfolio.

When interest rates go up, the value of a bond’s principal goes down. This is because one needs to invest less money to buy a bond that generates the same amount of income. Certainly, if you hold the bond until maturity, you will recover the full principal. But most people who buy marketable bonds don’t hold onto the bonds until maturity, but buy and sell them on the open market. This means that bonds are valued more for the income they produce than for their underlying value at maturity. Of course, the closer a bond is to maturity, the less impact changes in interest rates will have on its value.

So if you buy marketable bonds in a low interest rate environment, where interest rates are likely to increase, stick mainly to short-term bonds. (On the other hand, if interest rates are likely to drop, you can maximize your benefit by buying longer-term bonds.)

For More Information

For more information about using savings bonds as a college savings vehicle, please see the US Treasury’s Saving Bonds for Education web site. Other bond-related US Treasury web pages include:

• Series I Savings Bonds
• Series EE Savings Bonds