(Bloomberg) -- The golden age of I bonds may be coming to a close, but they still offer some perks. One often-overlooked use case: Saving for your kid’s future college tuition.
When used for higher education, the interest accrued on Series I savings bonds isn’t taxed by the federal government as long as the owner meets certain criteria, including an income cap.
For some people, that means putting money in I bonds can be comparable to saving for college expenses in 529 plans, and may help justify investing in the inflation-adjusted securities even as yields fall.
Read more: The Case for Cashing Out Your I Bonds With Yield Set to Drop
Choosing the right way to save for college is especially important given the rising cost of education — the price tag for a year at an Ivy League school is now close to $90,000, and out-of-state tuition at public schools costs $28,240 on average.
Like most investment opportunities, there are pros and cons, depending on your income and goals. The interest rate on I bonds — while very attractive at the current 6.89% — is likely to drop in the coming months and possibly years, as the Federal Reserve’s rate hikes cool inflation. Here’s what experts say you should know about the options for college savings.
When to Use I Bonds
With both I bonds and 529 plans, the investment returns aren’t subject to federal income tax as long as they’re used to pay for qualified education expenses. The interest earned on I bonds is also tax-exempt at the state and local level, while most states don’t tax withdrawals from 529 plans either.
One of the biggest differences between the two is how the money is invested. Through 529 plans, you can choose to put your savings in stock or bond funds, money market accounts or target-date funds based on your preferences and risk tolerance — similar to a 401(k). I bonds, by comparison, are a type of US government savings bond that’s considered relatively risk-free.
That safety and stability can be attractive for long-term savers, said Leyder Murillo, managing director at Wolfpack Wealth Management in Denver. For those without the stomach for risk or those who already have a portfolio of more volatile investments, putting cash in I bonds for college savings makes sense.
If your 529 plan is invested in stocks, it has the potential to grow faster since equities tend to have higher returns than bonds over the long term. However, that assumes you have time to wait out volatility. With recession worries on the horizon, many fear stock prices will drop.
Jeremy Keil, financial adviser at Keil Financial Partners in Wisconsin, recommends I bonds for those whose kids are currently in college or those who have kids going to college in the next few years — a period in which overall equity markets could experience some rockiness.
Just keep in mind that I bonds must be held for at least a year, and withdrawing the money before five years means forgoing the last three months of interest.
Gordon Achtermann, financial planner at Your Best Path Financial Planning in Virginia, said his advice for clients depends on how old their kids are. Those with children between the ages of 13 and 17 are the optimal group for investing in I bonds over 529 plans, he said. I bonds purchased when a child is 13 will reach the five-year threshold when the kid is about to start college. If they’re purchased when the child is 16, you can withdraw money penalty-free in their senior year.
There’s also no need to go all-in on one strategy. I bonds — which have a $10,000 annual contribution limit — could be a way to supplement savings in 529 plans and other investment accounts, said Karen Ogden, partner at Envest Asset Management in Connecticut.
When to Stick With 529 Plans
One of the best parts of 592 plans is that they can be opened by anyone. In comparison, I bond owners must meet a specific set of criteria to use the proceeds for higher education tax-free. First off, the owner must be at least 24 years old when the bond is issued, and you have to cash the bonds and pay for education in the same tax year in which you’re claiming the exclusion.
Your annual income also has to be below a certain level. For 2022, the cutoff was $100,800 for single individuals and $158,650 if married and filing jointly. That excludes a significant portion of parents paying for college, said Scott Cole, founder of Cole Financial Planning in Alabama.
Jennifer Marx, owner of Partner Financial Planning in Denver, recommends 529 plans over I bonds because they offer the potential for greater gains, especially if you invest while your child is still young.
“The funds in a 529 account can be properly diversified into the right mix of investments to match the investor’s timeline,” she said.
To contact the author of this story:
Claire Ballentine in New York at [email protected]
