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 more interesting as an option for those looking to pay for college expenses. Here are the other pros and cons of this approach:
- 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.
- 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 high yield now, but that yield can decline 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 Standard & Poor’s 500 Index, 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 the bonds, taking out a potentially huge chunk of your money that could be compounding.
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 few years, it’s unlikely to be a solid long-term solution for those looking to pay for the always-rising costs of college.