The Costs & Rewards of a College Education

Part 4 - College Funding Options: Savings Bonds & UGMA/UTMA Accounts

Education Bond Program

529 Plans and Coverdell Education Savings Accounts are good bets for some, but if you think your child may opt not to go to college, or if you just want more control over your investments, you may want to consider education bonds.

EE bonds and Series I bonds are both part of the Education Bond Program created by the Treasury Department in 1990.  A benefit of this program over the 529 plans is that with these investments you won't have to pay a penalty if you decide not to use them for your child's (or your own) education. If you do use them to pay for school, you will not be required to pay federal income tax on the interest you earn.  Bonds are available in denominations from $50 to $10,000 for EE bonds, and from $50 to $5,000 for I bonds.

EE bonds are purchased at 50% of their face value.  Therefore, a $100 EE bond will cost $50 to purchase it.  In contrast, I bonds are purchased at face value; therefore a $100 I bond will cost $100.

The Department of the Treasury sets the fixed rate for Series EE Savings Bonds administratively. The rate is based on 10-year Treasury note yields and adjusted for features unique to savings bonds, such as the tax deferral feature and the option to redeem the savings bonds at any time after the initial holding period.  Series EE Savings Bond rates are set every May 1st and November 1st, with each new rate effective for all bonds issued in the six months following the adjustment.

Series EE Savings Bonds issue dated on or after May 1, 2005 will earn a fixed rate of interest for 20 years, at which time the bond should have reached its face value. If the bond has not reached its face value, the Treasury will make a one time adjustment up to the face value. These EE bonds will increase in value every month instead of every six months. Interest is compounded semiannually. After the initial 20 yr period an additional 10 year extension and rate update will be initiated, for a total of 30 years of interest earning.

I bonds are inflation-indexed bonds with yields pegged to the inflation rate. You can learn more about these bonds online at www.savingsbonds.gov.  The bonds come with their share of caveats, so be sure you meet the requirements before you make a purchase.

Because of the $20,000 total bond limitation which began Jan. 2008 - you can now only purchase a maximum face value of $10,000 ($5,000 cash) in paper EE Savings Bonds a year. You may also purchase up to $5,000 in Electronic EE Savings Bonds, $5,000 in paper I Savings Bonds and $5,000 in Electronic I Savings Bonds - all in one calendar year.

To qualify for the tax exclusion, you must meet certain income guidelines when you redeem the bonds. For the 2008 tax year, for example, a single taxpayer's modified adjusted gross income must be less than $67,100 to take full advantage of the exclusion. The exclusion begins to be reduced at that point, and is eliminated for adjusted gross incomes of $82,100 and above. For married taxpayers filing jointly, those two numbers are $100,650 and $130,650, respectively. The good news is that those numbers are adjusted annually, so the ceilings may be much higher when you redeem your bonds.
Keep in mind that your adjusted gross income for the year you redeem your bonds includes all the interest earned on the bonds you cashed in. Ironically, this may actually push some families past the cut-offs, reducing or even eliminating their exclusion.

You can use the proceeds for tuition and fees, but not for room and board or books. Qualified expenses must also take into account any scholarships, fellowships, or other forms of tuition reduction and you must incur the expenses the same year you redeem the bonds.

If you redeem more cash in bonds than you use for educational expenses, the interest you earn will be taxed on a pro-rated basis.  For example, if you have a $10,000 bond consisting of $8,000 principal and $2,000 interest, and have $6,000 in expenses, you could exclude 60 percent of the earned interest, or $1,200. The other $800 would be subject to taxes.


UGMA/UTMA Custodial Accounts

A custodial account provides a way for a donor (usually parents or grandparents) to gift cash and/or assets to a minor via a simple and cost effective account.  The Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) account enables the custodian to provide management of the account and to direct distributions for the benefit of the child until the child reaches the age in which they can control the account, usually age 18 or 21.  For estate tax purposes, if the donor and the custodian is the same person and if they predecease the beneficiary before the age of majority, the gift amount will not be considered a completed gift.  Specific terms of UGMA and UTMA accounts are determined by state statute.

Neither the donor nor the custodian can place any restrictions on the use of the money when the minor becomes an adult. At that time the child can use the money for any purpose whatsoever without requiring permission of the custodian, so there's no guarantee that the child will use the money for education purposes. Since UGMA and UTMA accounts are in the name of a single child, the funds are not transferable to another beneficiary.

The income from the custodial account must be reported on the child's tax return and is taxed at the child's rate. There is no special tax treatment for UGMA/UTMA accounts.

Uniform Transfer to Minors Act (UTMA) is the most common custodial account and allows for a minor to own securities and other types of property, such as real estate, fine art, patents and royalties, and for the transfers to occur through inheritance.  The Uniform Gift to Minors Act (UMGA) allows for a minor to own securities.  UTMAs are slightly more flexible than UGMAs.   For college financial aid purposes, custodial accounts are considered assets of the student. This means there is a high impact on financial aid eligibility.

Next week I will touch on some final, less popular, college funding options which include using your IRA accounts, using variable life insurance policies, and the loyalty/rebate programs.