With the end-of-the-year holidays approaching, many generous grandparents are looking for ways to pass on some financial gifts to their grandchildren. But letting clients give savings bonds as presents only guarantees the family will be stuck with an investment that offers a low rate of return and a high degree of hassle.
Here are several reasons why helping those well-intentioned clients use 529 college savings plans instead will make the grandparents and their grandchildren happier now, as well as in the future.
Low Risk, Less Reward
The EE and I bonds issued by Uncle Sam are not completely without merit, as the principal and interest are backed by the full faith and credit of the United States Treasury.
But like most other safer paper, yields on savings bonds are currently near all-time lows. Right now EE bonds pay just 1.7 percent interest. The I bonds have a fixed rate of 0.3 percent that is added to an inflation-adjusted rate of 3.06 percent, for a total current yield of 3.36 percent.
Compare those figures to the inflation rate in college costs over the last 40 years or so — which, according to the College Board, have increased at a yearly rate of about 7.2 percent, versus 4.4 percent annual general inflation over the same period.
True, the equity and bond fund options within the 529 accounts also have a downside risk that the savings bonds don't. But at least the variable college savings plan investment choices give families a fighting chance of meeting or beating the rise in the cost of going to college — as opposed to savings bonds, which only guarantee that they won't keep pace.
Besides, even conservative savers can find a safer haven within 529s, as several plans now offer federally-insured certificates of deposit on the investment option roster.
Tricky Tax Savings
It is possible for families to cash in savings bonds and avoid paying taxes on the accrued interest when the proceeds are used to pay for college costs. But the restrictions are more difficult to decipher than an advanced-level calculus lecture.
First, the bonds must be owned by the parent, not the student (and forget about getting the tax breaks for bonds owned by grandparents). Then the proceeds can only be used tax-free for tuition expenses, not room and board.
Finally, the parents' income must be below stringent limits that are adjusted each year. So not only may the family make too much money to qualify, they don't even know what the figure will be when they cash in the bonds.
Contrast that with the more egalitarian nature of 529 plans, which have no income or wealth restrictions on depositors. And withdrawals from 529 plans are tax-free for all qualified higher education expenses — not just tuition, and with no regard for family's income.
Both 529 plans and savings bonds offer the ability to make relatively small initial and ongoing deposits — usually as little as $25 a pop.
But current savings bonds rules only allow purchases of up to $10,000 per Social Security number per calendar year: $5,000 in person, and $5,000 electronically (i.e. via the Treasury Direct program at savingsbonds.gov).
There is a much higher ceiling on the amount of money that can be deposited into a 529 plan for a particular beneficiary. Current rules say that each grandparent can contribute up to $13,000 to a 529 plan each year, as long as no other gifts are made from the donor to the beneficiary.
And using the five-year exemption available only to 529 plans lets grandparents make five years worth of maximum deposits all at once, for a total right now of $65,000.
So in theory, today a grandmother and grandfather could give separate gifts totaling $130,000 to a 529 plan for each fortunate grandchild, without running afoul of the tax code.
Lower Estate Taxes
That special exemption highlights another advantage uniquely available to 529 plans. Remember that to cash in savings bonds proceeds tax-free, the expenses are limited to tuition incurred by the dependent children of the bonds' owners.
In theory, benevolent grandparents could give the money to their adult children, who would (hopefully) buy bonds for the grandchildren that then one day might (or might not) be redeemed tax-free. As a side benefit, in the process the gift will be removed from the grandparents' taxable estates.
But grandparents who make deposits into 529 plans for grandchildren can also remove the money from their taxable estates, yet still maintain ownership of the accounts.
So if your clients need the money for other purposes, they can pull it out of the 529, pay a small amount in taxes and penalties on the earnings portion of the withdrawal, and do what they please with the net proceeds.
This should give the grandchildren that much more motivation to send a “thank you” note to the grandparents soon after the holidays are over.
Kevin McKinley CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the “Generations” columnist for Registered Rep. magazine and the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.mckinleymoney.com.
18/Comings & Goings