How To Use Series I Bonds For College Savings | Bankrate (2024)

How To Use Series I Bonds For College Savings | Bankrate (1)

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Series I bonds have been one of the hottest investments recently. The bond gives savers the safety of a U.S. government-backed security mixed with inflation protection, resulting in a composite rate that’s currently 4.3 percent annually.

Now, given that solid yield, some investors may be wondering whether they can use the Series I bond in place of a 529 account to save for college expenses. Here are the pros and cons of that approach and why you might or might not want to use the Series I bond for college savings.

What is a Series I bond and how does it work?

A Series I bond, also known as an I bond, earns interest in two ways: a fixed interest rate and a variable rate that adjusts to the level of inflation every six months. The variable rate adjusts higher or lower as inflation rises or falls, offsetting the impact of inflation and protecting your money’s purchasing power.

Currently, the bond yields 4.3 percent, and anyone who purchases the bond while it offers that rate (through Oct. 31, 2023) will enjoy the payout for a full six months. Then they’ll enjoy the new interest rate announced in November for an additional six months and so on. The bond earns interest for up to 30 years or until you cash it.

The bond also offers some tax advantages, including being tax-free at the state and local levels. In addition, if the bonds are used for qualified education expenses, then taxpayers may exclude the interest on their bonds from their federal tax returns, too (more below). Plus, with the backing of the federal government, it’s one of the safest bonds in the world.

Series I bonds cannot be cashed in for the first 12 months that they’ve been owned, and if you cash them in before five years, you’ll surrender the last three months’ worth of interest on them.

Normally, you’ll be able to purchase only $10,000 of Series I bonds in a year, though up to $5,000 more can be purchased with a tax refund. But those who are willing to do extra legwork have found a workaround that allows you to purchase an unlimited amount of these bonds.

However, Series I bonds cannot be purchased within the tax-advantaged confines of an IRA.

Using Series I bonds for college savings

Series I bonds may be an attractive option, at least while they’re yielding a high rate, for saving for college. The federal government allows qualified holders of Series I bonds – and Series EE bonds, too – to exclude from their income any interest paid when the bonds are cashed as long as the bond owner pays qualified education expenses at an eligible educational institution.

The rules for claiming the exclusion can be strict and the taxpayer looking to do so must meet all five of the following criteria:

  • You cashed Series I or Series EE bonds issued after 1989 in your name in the same tax year that you’re claiming the exclusion.
  • You paid qualified educational expenses in that same tax year for yourself, your spouse or dependents.
  • Your tax filing status is anything but married filing separately.
  • Your modified adjusted gross income is less than $98,000 if single, head of household or qualifying widower, or $124,800 if married filing jointly (in 2022). This number typically increases each year and IRS Form 8815 shows each year’s exclusion.
  • You were already age 24 or older before your savings bonds were issued.

The bonds must be in your name, or in your name and your spouse’s name if married. A bond purchased by a parent and issued in the name of a child under age 24 is not eligible to be excluded by either the parent or the child.

That’s a stringent list needed for the interest exclusion, and that’s on top of ensuring that your education expenses themselves are qualified. Such expenses include tuition, fees, student activity fees and related expenses required for enrollment at an eligible institution. The expenses must be for an academic period in that tax year or in the three months of the next tax year.

The pros and cons of the Series I bond for college savings

The interest exclusion can make Series I bonds an interesting option for those looking to pay for college expenses. Here are the other pros and cons of this approach:

Pros

  • Inflation protection: The Series I bond offers inflation protection, and that’s one of its biggest draws, ensuring that you aren’t losing purchasing power.
  • Safety: The bond is also great for its safety, and is backed by the U.S. federal government.
  • Current high yield: The Series I bond currently pays an attractive interest rate, despite its high level of safety.
  • Tax exclusion: Investors have the ability to exclude taxes on the bond’s interest if it’s used to pay for qualified educational expenses in the same year it’s cashed.
  • No taxes at state and local levels: Investors can avoid taxes on Series I bonds at the state and local levels, ensuring that all the bond’s interest goes to expenses.

Cons

  • No federal tax protection unless used for education: You’ll lose the federal tax exclusion of your Series I bonds if they’re not used for educational purposes. You may save for years and then realize you won’t use the bonds for educational expenses.
  • Yield may adjust lower: The Series I bonds offer a solid yield now, but that yield declines as inflation falls, and the Fed has been on a mission to stamp out inflation. For example, from April to October 2022 the Series I bond was paying 9.62 percent.
  • May not yield and compound well over time: A declining yield is almost certain to happen sooner or later considering that the Fed is raising interest rates, and today’s high yield may never return. Those investing in Series I bonds over the last decade, when inflation and interest rates were low, would likely be disappointed with the yields they received then.
  • Lower current yield than a well-diversified portfolio of stocks: Yields on Series I bonds are high now, but they’re still lower than the long-term return on the , a collection of hundreds of America’s top companies. Your investment could perform much better (but also much worse, to be fair) with stocks, and the best 529 plans offer a good selection of low-cost stock funds.
  • Taxable if transferred to a 529 plan: If you decide later that you want to move your I bonds to a 529 plan or another investment vehicle, you’ll pay taxes when you cash in the bonds, taking out a potentially huge chunk of your money that could be compounding.

Bottom line

Series I bonds may make a compelling choice to pay for educational expenses this year or next, but the real test will come over time. For the Series I bond to remain a compelling investment for education, inflation will need to remain high, a situation that the Federal Reserve is actively combatting. So, while the Series I bond may remain attractive for the next couple of years, it’s unlikely to be a solid long-term solution for those looking to pay for the always-rising costs of college.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

As an enthusiast with a demonstrated understanding of financial instruments and investment strategies, I bring forth a wealth of knowledge in the realm of Series I bonds and their application in personal finance. My experience encompasses a deep dive into the intricacies of various investment tools, and I have closely followed the trends and developments in the financial market.

Now, let's dissect the information presented in the article:

Series I Bonds Overview:

A Series I bond is a U.S. government-backed security that combines a fixed interest rate with a variable rate tied to inflation. The variable rate adjusts every six months, providing a hedge against inflation and preserving the bondholder's purchasing power. Currently yielding 4.3 percent annually, the bond offers safety and certain tax advantages.

How Series I Bonds Work:

  • Interest: Earns interest through a fixed and variable rate.
  • Inflation Protection: Adjusts for inflation, ensuring the real value of the investment.
  • Tax Advantages: Tax-free at the state and local levels; interest exclusion for qualified education expenses at the federal level.

Purchase Limitations and Restrictions:

  • Initial 12-month restriction on cashing the bonds.
  • Surrendering three months' interest if cashed before five years.
  • Annual purchase limit of $10,000, with potential for an additional $5,000 through tax refunds.
  • Cannot be purchased within an IRA.

Using Series I Bonds for College Savings:

  • Qualified Education Expenses: Series I bondholders can exclude interest from federal tax returns when used for qualified education expenses.
  • Stringent Criteria: Specific conditions, including age restrictions and income limits, must be met for the interest exclusion.
  • Qualified Expenses: Include tuition, fees, student activity fees, and related enrollment expenses.

Pros and Cons of Series I Bonds for College Savings:

Pros:

  1. Inflation Protection: Preserves purchasing power.
  2. Safety: Backed by the U.S. federal government.
  3. Current High Yield: Offers an attractive interest rate.
  4. Tax Exclusion: Interest excluded from federal tax returns for educational expenses.
  5. No Taxes at State and Local Levels: Ensures tax-free status locally.

Cons:

  1. No Federal Tax Protection Unless Used for Education: Losing tax exclusion if not used for educational purposes.
  2. Yield Adjustment: Declining yield as inflation falls.
  3. May Not Yield and Compound Well Over Time: Potential disappointment in long-term performance.
  4. Lower Current Yield Than Stocks: Lower than the long-term return of well-diversified stock portfolios.
  5. Taxable if Transferred to a 529 Plan: Tax implications if moved to a 529 plan or another investment vehicle.

Bottom Line:

While Series I bonds may be an appealing choice for immediate educational expenses, their long-term viability depends on factors such as inflation rates, which the Federal Reserve actively manages. Although attractive in the short term, Series I bonds might not be a solid, enduring solution for addressing the continually rising costs of college.

Editorial Disclaimer: Investors are advised to conduct independent research and past performance doesn't guarantee future results. Individual circumstances and market conditions should be considered before making investment decisions.

How To Use Series I Bonds For College Savings | Bankrate (2024)
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