From the U.S. Department of the Treasury Bureau of the Public Dept

When considering your savings mix for a child's education, savings bonds offer unique advantages.

U.S. Savings Bonds can be an attractive addition to your education savings portfolio. While other investment options may promise higher rates of return or other attractive features, the particular strengths of savings bonds can offer a strong diversification element to your education savings program.

A typical education savings program likely includes some combination of stocks, mutual funds, certificates of deposit, education IRAs, and/or cash invested in state-sponsored education investment programs. Many investment advisors favor such a diversified approach. Savings bonds can add further diversification by providing a reliable, steady-growth option, and one that can carry significant tax advantages.

Savings bonds are a safe, secure investment backed by the United States government. Unlike some other investments, they're designed never to decrease in value. Two types of U.S. Savings Bonds — EE and I — are appropriate for education savings purposes. Available in both paper and electronic forms, EE and I bonds earn interest monthly, which compounds semi-annually, and is paid when the bonds are redeemed.

Savings bonds also have tax advantages. Interest on savings bonds is always exempt from state and local income taxes. EE and I bonds also have specific education-related federal tax benefits. For EE bonds issued January 1990 or later and I bonds, the Education Bond Program allows some or all interest to be excluded from federal income tax when the bonds are redeemed in the year that eligible education expenses are incurred and other requirements are fulfilled. Tax savings can enhance overall yield on EE or I bonds. To qualify for this exclusion, bonds should be registered in the name of a parent (or parent and spouse), not in the child's name.

The exclusion from federal tax also applies when EE and I bonds are redeemed and payments are made in the same year to state tuition plans (529 plans).

Eligible education expenses are tuition and fees paid to colleges, universities and vocational schools that qualify for guaranteed student loan programs. Income limitations, age and other restrictions apply to the person claiming the tax exclusion.

Parents who don't expect to meet the income limits for this tax exclusion should consider buying savings bonds in the name of the child instead and reporting the child's interest annually. This alternate approach can eliminate taxes on interest earnings during years when the child's income is low.

As always, it is wise to check with a professional financial/tax advisor. For complete information on the limitations and restrictions, see IRS Publication 970, "Tax Benefits for Higher Education".

Last Updated August 4, 2006