EE Bonds

Ever since the U.S. government improved the return on Series EE savings bonds to enable them to compete more effectively against other financial products, they have been a convenient way to save small sums systematically for a college fund.

What Are U.S. Savings Bonds?

U.S. savings bonds, like Treasuries, have the full faith and credit of the U.S. government backing them. But they are designed for individual savers. They are also issued in smaller denominations and do not trade on the financial exchanges. The face value on Series EE bonds can be $50, $75, $100, $500, $1,000, $5,000, or $10,000. The initial cost is half the face value of the bond. Interest then accumulates at a rate that is 85% of the average yield on marketable Treasury securities with five-year maturities or 6% a year, whichever is higher. The interest rate is calculated every six months and becomes effective May I and November 1. If the average rate on five-year Treasuries in the previous six months is 8.5%, for instance, the rate on savings bonds for the next six months will be 7.2%. In order to receive that rate (or the minimum 6% guarantee), investors must hold the bonds for at least five years.

Buying the bonds is simple and banks can usually provide an application (PD 4882). The bank can generally issue the savings bond or an application, along with a check, can be sent to a nearby Federal Reserve Bank. To find out what the current rate on savings bonds is, call toll-free: 1-800-US BONDS.

The Pros & Cons Of Using Savings Bonds For College

The interest for U.S. EE Bond redemptions, used to pay for qualified education expenses, is tax-free. To qualify for the income exclusion, the bonds must be issued after December 31, 1989, and purchased by an individual who is 24 years of age or older [IRC Sec. 135(c)(1)]. Bond proceeds must be used to pay qualified higher education expenses of the taxpayer, spouse, or any dependent [IRC Sec. 135(a)].

If a taxpayer’s redemption proceeds (interest and principal) exceed the qualified education expenses for that year; a rateable portion of the interest proceeds is taxable.

Example: If a taxpayer redeems $10,000 ($5,000 interest and $5,000 principal) and pays only $6,000 in qualified expenses, $3,000 of the interest would be taxable ($6,000 / $10,000 = 60% x $5,000 =$3,000 taxable interest).

The tax-free interest is phased out when the taxpayer reaches certain levels of Modified Adjusted Gross Income. It is phased out when the Modified AGI is between $77,550 to $92,550 for single or head of household taxpayers and between $111,300 to $131,300 for married taxpayers. These phase-out levels are adjusted yearly for inflation. Married taxpayers must file a joint return for the tax year in which education expenses are paid to exclude interest from Series EE Bonds.

Qualified education expenses for the purpose of this tax benefit are defined as tuition and related fees at an eligible educational institution. For tax years beginning after December 31, 1997, the transfer of bond redemption proceeds to a Qualified Tuition Program or to a CESA for the taxpayer, the taxpayer’s spouse or taxpayer’s dependent is considered a qualified education expense. However, the amount of tax-free interest claimed by the taxpayer will reduce the qualified expenses used in the calculation of the American Opportunity Credit and Lifetime Learning Credit.

To be eligible for the tax-free interest benefit the student must be the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent and the student must have been enrolled at an eligible institution. Married taxpayers must file a joint return to be eligible for the tax-free redemption.



Investors may purchase the Treasury’s new “I-Bond” which provides a return that rises and falls with inflation. The bonds are issued at face value in amounts of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Only $10,000 of I-Bonds may be purchased in any calendar year. I-Bonds may be purchased from most banks, credit unions, or savings institutions.

Earnings from the new I-Bonds are determined by two rates. The interest rate, set by the Treasury Department every six months (May 1 and November 1 for new issues), remains constant for the life of the bond. The second, a rate of inflation applied to the bond principal, is determined every six months by the Bureau of Labor Statistics to reflect changes in a version of the Consumer Price Index. Accordingly, the fixed rate is applied to a principal value which is compounding regularly due to the semi-annual inflation adjustment. If deflation sets in, a decline in the Consumer Price Index would not reduce the redemption value of the bond. For current rates and in-depth rate computation, refer to

Investors may defer paying taxes on their interest, which is automatically reinvested and added to the principal. Tax reporting is similar to reporting on EE bonds; the Federal tax on the interest may be deferred until the bond is redeemed or the bond reaches maturity in thirty years. This is unlike previous inflation-indexed bonds that were taxed under the original issue discount (OID) rules (that is, the holder of the bond had to pay interest as it accrued, not at the time of maturity).

If the I Bond is owned by a child currently in a low tax bracket and who expects later to be in a higher tax bracket, the child may elect the accrual method of reporting the interest and pay taxes currently on the income.

As with traditional savings bonds, the I-Bond interest is exempt from state and local taxes. Holders will forfeit three months of interest if an I-Bond is redeemed within the first five years. For example, if the bond is redeemed after holding it one year, interest on it will only be received for nine months. Bonds are not redeemable within the first six months.

Observation: If the bond is redeemed to pay for college tuition or other college fees, all or part of the interest may be excludable from income per IRC Sec. 135 if modified adjusted income is under an annual phase-out limit; this is the same exclusion rule as for EE Bonds used for tuition. However, this exclusion only applies if the bond is purchased by a taxpayer age 24 or older. Thus, for affluent parents, the Section 135 exclusion is not relevant.

Example: A parent with high taxable income adopts the strategy of purchasing a $5,000 I-Bond annually as a gift to a child, doing so for 16 years (from age 3 to age 18 of the child, for a total investment of $80,000). Assuming that these I-Bonds averaged a 7% overall yield, and that the child cashed in the I-Bonds equally over the next four years for college costs, the average annual withdrawals would be $41,200. On average, the child would recognize $21,200 of Federal taxable income per year [$164,800 total withdrawals (4 x $41,200), less total investment of $80,000, divided by 4 years equals average income of $21,200]. This income would be taxed in the child’s return but may be subject to kiddie tax, and annually could be offset by college credits of $2,000 to $2,500. There would be no state or local tax on these earnings.


Zero Coupon Bonds

Zero coupon bonds may be the backbone of many families’ college funds. The reason for this is that the investment return is so easy to understand. The unique value of all zero coupon bonds (treasury zero bonds, municipal zero bonds, and zero corporate bonds) is that a specific amount can be invested today and the investor knows exactly what the investment will be worth at maturity. A current rate of interest can be locked in for the long term.

What Are Zero Coupon Bonds?

The owner of a traditional coupon bond receives regular interest payments and then must reinvest that interest at whatever rate the market offers at the time. Zeros, however, pay no regular interest. In fact, they pay nothing at all until they actually mature. Rather, a zero coupon security is bought at a discount from its face value. In general, the longer the time until maturity, the more substantial the discount. The return is the difference between what is paid for the zero bond at the time of purchase and what it sells for or what it pays when held to maturity.

Obviously, if interest rates go down while holding a zero bond, it’s owner will do very well because they are locked into a higher rate. If rates go up during that period, however, the owner will do worse than someone who could reinvest interest at the higher rates. However, the rate of return earned will be assured when the bond is held until maturity.

The following are the four types of zero coupon bonds:

  1. Zero Coupon Treasury Bonds – These are actually U.S. Treasury bonds or notes that have been stripped of their coupons by the Treasury. A broker, bank, or other institution then markets the stripped bonds at a discount and the purchaser receives the face amount at maturity.
  2. Zero Coupon Certificates of Deposit – These CDs are issued by banks and are insured up to the FDIC rate ($250,000). They are offered at a larger discount than the ZC Treasury Bonds, thereby giving the investor a higher return on investment.
  3. Zero Coupon Corporate Bonds – These bonds are issued by corporations and provide a greater rate of return than either ZC Treasury Bonds or ZC CDs because they are not Insured against the corporation defaulting at maturity and the investor assumes more risk.
  4. Zero Coupon Municipal Bonds – These bonds are similar to municipal bonds in that they provide interest income that is not subject to federal and state taxes.

The Pros & Cons Of Using Zero Coupon Bonds For College

The following are benefits common to most Zero Coupon Bonds:

  • If the bonds are held to maturity, the investor is assured of a specific yield.
  • A relatively small investment is required to purchase Zero Coupon Bonds.
  • Yields are usually higher than most other Treasuries.
  • Maturities can be staggered so the bonds mature as the proceeds are needed.

The disadvantages of Zero Coupon Bonds are:

  • The investor receives no interest until the bond matures, but the accrued interest is taxable.
  • Unless it is held until maturity, the longer the term of the bond, the greater the possible volatility of the bond price.
  • If the issuer defaults, the bond will have a zero return as interest is paid only at maturity.

If the maturity of zero bonds are timed to when the cash is needed, zero coupon bonds are a very handy way to match a child’s projected college expenses with an investment that will have a specific, predictable value at that time. The difference between what the initial cost for the zero bond and what it can be cashed in for at maturity, is a true compounded rate of interest; as if that interest had actually been paid to you several times a year and reinvested it at the same rate each time. Compound interest is a powerful engine for growth.


Tax-Free (Municipal) Bonds

As soon as the federal government trimmed opportunities to cut taxes by shifting income to children, municipal bonds became far more attractive to parents as a college-fund building block. Even though federal tax rates are lower than they have been for years, the appeal of not paying taxes on income is so great that many individuals continue to invest in municipals. One important consideration tipping the scale in favor of municipals for many long-term investors, of course, has been their concern that federal tax rates will continue to rise. Clearly, establishing that a municipal-bond investment is tax-free is only the first step in making a sound decision to add them to your college fund.

What Are Municipal Bonds?

Municipal bonds are the debt securities issued by state and local governments or by local authorities considered to be municipal entities under state laws. While municipal bonds are issued for a variety of purposes, state and local governments generally issue debt to raise capital necessary to finance infrastructure projects. Local authorities, on the other hand, issue municipal bonds to provide capital for non-profit governmental services such as public power, waste management, utilities (water and sewer), and hospitals.

Municipal governments are granted the right under federal tax laws to sell their securities free of federal income tax on interest paid to the investor. In most cases, state and local laws allow tax exemptions on an investor’s interest earnings on municipal debt securities issued within the specific state. Municipal interest earnings on certain investments, therefore, are tax-free at the state and local level as well as the federal level.

The most common type of municipal bonds are the general-obligation bonds (GOs), backed by the full faith and credit of the state or city government. This means that the bonds are secured by the taxing power of the entity that issues them. Because of the full-faith and credit pledge, these bonds are generally considered the most secure. Since local governments generally rely heavily on property and income taxes for revenues, bonds issued by communities with rising real-estate values, good demographic trends, a positive image with industry, and a history of being able to raise appropriate taxes get the best ratings.

Revenue bonds are the other chief category of municipals. Principal and interest on these bonds is paid back to bondholders from revenues generated by a specific project, such as the operation of a road, bridge, public utility, or water-treatment plant. Historically, investors consider GOs to be higher-quality municipals than revenue bonds, but it can be a mistake to invest on that premise without looking more closely at the issue under consideration. A number of revenue bonds actually have higher ratings than some GOs.

The Pros & Cons Of Using Municipal (Tax-free) Bonds For College

As a first step, check the expected yield on any tax-free municipal investment under consideration. Use the following table to compare the expected municipal yield against the equivalent yield for a fully taxed investment. This will be the yield the taxable security needs to equal a tax-free return on a tax-free municipal bond. Some states tax the interest earned by their citizens on bonds issued by other states. And if an investor lives in a city that levies an income tax, they may have to ask a broker for municipals that qualify as “triple-tax free.” Should an investor choose to put a good share of the college fund into municipals, however, it is advised to diversify the holdings among a variety of issuers. Those living in a state where they may buy out-of-state bonds and avoid state taxes on the income, should consider taking advantage of this opportunity to diversify geographically.

It takes a great deal of special expertise to evaluate whether the stream of revenues pledged to the payment of municipal securities is sufficient to meet obligations in a timely manner. Adding to the complexity, the Securities and Exchange Commission does not set standards for what must be disclosed by issuers. The states and municipalities raising the money provide information voluntarily, though they have to respond to any demands for clarification made by the securities dealers who sell the issues to investors.

Municipals are, nevertheless, generally accepted to be second only to U.S. government securities in safety. The municipal default rate overall has been less than 1% since the depression of the 1930’s. Assessing the likelihood that any problem will arise in the prompt payment of interest is the job of the major bond-rating agencies, Moody’s Investor Service and Standard & Poor’s. On bonds which are rated by these agencies, a municipal entity’s ability to pay is assessed at the time of issuance, with updates provided throughout the life of the bonds as deemed necessary by the rating agencies. The rating agency will include numerous in-depth reviews to determine an entity’s ability to pay the principal and interest on time.

Since there are hundreds of thousands of municipal issues on the market, not all of them are rated. Limit the choices for a college fund, though, to those that are rated and are at least investment-grade. Insured bonds are especially attractive for college-fund investments. The added safety factors are probably worth the modest loss of yield. Remember, insurance applies only to the payment of interest and principal. It will not protect you against market risk if interest rates go up. The investor must be comfortable with owning the underlying credit quality.