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.
There is an annual purchase limit of $30,000 per owner for Series EE
Bonds and
$30,000 for Series I Bonds. A husband and wife purchasing bonds as
co-owners may purchase up to $60,000 in bonds in a single year.
The purchase limit for Series I Bonds isn't affected by purchases of
Series EE Bonds and vice versa.
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
exclusion on the grandparents' income tax return.)
Parents who are married must file a joint income tax return to
qualify for the interest tax exclusion.
The parents must keep detailed records on the educational expenses
paid and the bonds used for education. For the bonds this information
includes the serial number, face value, date issued, date redeemed and
total proceeds. For the educational expenses this information includes
the educational institution, the date paid and the amount of the
qualified expenses.
IRS Form 8815 (Exclusion of Interest From Series EE US Savings Bonds
Issued After 1989) is used to exclude the interest on your income tax return.
You may also find IRS Form 8818 (Optional Form to Record Redemption of
College Savings Bonds) helpful in keeping track of your redemptions.
If the full proceeds of the bond redemption are not used for qualified
education expenses, the amount of excludable interest is reduced pro rata.
There are income phaseouts on the interest exclusion, based on the
year in which you redeem the bonds, not the year you buy the
bonds. For 2006, the income phaseouts are $63,100 to $78,100 for
single filers and $94,700 to $124,700 for married taxpayers filing
jointly. (There is a pro-rata reduction in the exclusion within the
ranges.) The income limits are adjusted annually for inflation and
rounded to the nearest $50. Income is defined to be modified adjusted
gross income, which is the adjusted gross income including interest on
US Savings Bonds, but taking into account the partial exclusion of
certain retirement benefits, adjustments for contributions to
retirement savings, and adjustments for limitations on passive
activity losses and credits.
Interest is also exempt from state and local taxes.
If you accidentally purchased the bonds in your child's name, you may
have them reissued in your name so long as the funds used to buy the
bonds didn't belong to your children and were purchased after December
31, 1989.
Note that if the savings bonds are registered in the
child's name
they are not eligible for the education bond interest exclusion. However,
the interest on the bonds will be taxed at the
child's income tax rate, which
may still offer some tax savings.
Series EE Savings Bonds
Series EE Savings Bonds are issued at 50% of face value, meaning that
a $100 EE Bond costs $50. They are offered in 8 denominations, which
include $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Each
individual may purchase up to $30,000 face value ($15,000 issue price)
of Series EE Savings Bonds per year.
The interest on Series EE Savings Bonds is calculated at 90% of the
6-month averages of the yields on 5-year Treasury Securities. Rates
are announced every May 1 and November 1. Series EE Savings Bonds are
guaranteed to reach their face value in 17 years. (If the bond has not
doubled in value in 17 years, the Treasury Department makes a one-time
adjustment to bring the bond up to face value. This means the bond has
a minimum guaranteed rate of return, if you hold it for 17 years until
original maturity, of 4.16%.)
Series EE Savings Bonds are accrual or appreciation-type securities,
which means their
redemption value increases periodically as interest is added to the
security's principal. Interest accrues on such a bond and becomes part
of the redemption value (principal + interest) which is paid when the
bond is redeemed. Series EE Savings Bonds increase in value monthly
(on the first of the month) and the interest is compounded semiannually (every 6 months).
Series EE Savings Bonds can be redeemed after the first 6 months.
If you redeem the bonds during the first five years after the date of
issue, there is an early redemption penalty that forfeits three months
of interest.
The bonds can
continue to earn interest up to 30 years from the date of issue.
Savings bonds are exempt from state and local income tax.
Federal income tax may be deferred until you redeem the bonds or the
maturity date (30 years), whichever comes first, and may
be
exempt from federal income tax
if used to pay qualified higher education expenses.
Savings bonds can be purchased through a
Payroll Savings Plan
if your
employer participates. Alternately, you can buy them directly through
the
EasySaver Plan
which lets you purchase bonds automatically through
transfers from your checking or savings account. Savings bonds may
also be purchased online at
Savings Bonds Direct.
Savings Bonds can also be purchased at most banks.
Series I Savings Bonds
Series I Savings Bonds protect the purchasing power of an investment
and earn a guaranteed rate of return by combining a semiannual
inflation rate adjustment with a fixed base rate of return.
Series I Savings Bonds are issued at full face value, meaning that
a $100 I Bond costs $100. They are offered in 8 denominations, which
include $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Each
individual may purchase up to $30,000 face value ($30,000 issue price)
of Series I Savings Bonds per year.
Series I Savings Bonds earn interest as a combination of a fixed rate
of return and a semiannual inflation rate adjustment based on the
Consumer Price Index for All Urban Consumers (CPI-U).
In periods of deflation, if CPI-U is negative and greater in magnitude
than the fixed rate, the redemption value of the bonds will remain
unchanged until the combined earnings rate becomes greater than zero.
Series I Savings Bonds are an attractive component of a college
savings plan because the inflation adjustment offers a hedge against
inflation while the fixed rate of return ensures some additional
return on your investment.
Fixed rates and inflation adjustments on new bonds are announced every May 1 and November 1.
Series I Savings Bonds are accrual or appreciation-type securities,
which means their
redemption value increases periodically as interest is added to the
security's principal. Interest accrues on such a bond and becomes part
of the redemption value (principal + interest) which is paid when the
bond is redeemed. Series I Savings Bonds generally increase in value monthly
(on the first of the month) and the interest is compounded semiannually (every 6 months).
Series I Savings Bonds can be redeemed after the first 6 months. If
you redeem the bonds during the first five years after the date of
issue, there is an early redemption penalty that forfeits three months
of interest. The bonds can
continue to earn interest up to 30 years from the date of issue.
Savings bonds are exempt from state and local income tax.
Federal income tax may be deferred until you redeem the bonds or the
maturity date (30 years), whichever comes first, and may
be
exempt from federal income tax
if used to pay qualified higher education expenses.
Savings bonds can be purchased through a Payroll Savings Plan if your
employer participates. Alternately, you can buy them directly through
the EasySaver Plan which lets you purchase bonds automatically through
transfers from your checking or savings account. Savings bonds may
also be purchased online at
Savings Bonds Direct.
Albert Einstein appears on the $1,000 Series I Savings Bond.
US Treasury Inflation-Indexed Securities
The US Treasury also sells marketable
Treasury
Inflation-Index Securities (TIPS),
which are similar to Series I Savings Bonds. However, TIPS do not have
the special education tax treatment of Series I Savings Bonds.
Accordingly, most families interested in inflation-adjusted
investments will be better off purchasing Series I Savings Bonds
instead.
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.
Interest must be reported as income in the year in which it is earned,
even though it isn't received until maturity or the STRIPS are sold.
STRIPS are more popular components of tax-deferred accounts
(retirement accounts and 401(K) plans) and non-taxable accounts
(pension funds) for this reason.
The market prices of STRIPS tend to fluctuate more than the prices of
the fully constituted security of the same maturity, because a STRIP
represents a payment on a specific date while the original security
represented a series of payments.
If a STRIP is held until maturity, the investor will earn the
difference between the purchase price and the redemption value as
income. If the STRIP is sold before maturity, the investor may realize
a gain or loss depending on the market price. This is because the
market price is based on the amount of future earnings and the current
prevailing interest rate. If interest rates have gone up, a smaller
amount of principal is necessary to earn the same amount of earnings,
and so the market price goes down, leading to a loss. On the other
hand, if interest rates have gone down, the investor could sell at a
gain.
Zero Coupon Bonds may be of interest for college savings because they
effectively guaranteed a specific return on investment on a
pre-determined date. They also offer a hedge against a souring
economy, because their market value increases when interest rates go
down. However, many parents will not be interested in them because of
the tax treatment, the potential for principal risk and the difficulty
in understanding the market price movements for such bonds. Only more
sophisticated investors should consider using zero coupon bonds.
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:
Questions about savings bonds may be sent to the Bureau of the Public
Debt's savings bond operations office at
SavBonds@bpd.treas.gov.
Current rate information may be obtained by calling 1-800-4US-BOND
(1-800-487-2663) or visiting www.savingsbonds.gov.
See also
IRS Publication 550 (Investment Income and Expenses) and
IRS
Publication 970 (Tax Benefits for Higher Education).
