Saving for College with U.S. Savings Bonds: Choosing Savings Bonds

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When members of Congress first dabbled with the idea of giving taxpayers incentives to save for college expenses, they didn't roll out some fancy new plan or program, creating unnecessary complexity (they saved that for much later). And they also didn't want to target the upper and upper-middle classes — they figured that those folks could pay for college expenses on their own. Instead, they looked to the solidly middle class, checked out the ever dropping savings rate, and built a new savings perk into an already existing savings option that people viewed as generally stodgy and unexciting: U.S. Savings Bonds.

U.S. Savings Bonds, specifically Series EE and the new Series I bonds, remain a stodgy and unexciting way to save. Which is why you may be surprised to find out that these small pieces of the national debt can often provide you with a great tax-saving option: When you use them to pay for qualified higher education expenses, you're allowed to exclude from your taxable income all the interest you've earned on them over the years.

You may use any sort of U.S. Treasury obligation, from bonds, notes, and T-bills all the way to Series EE, Series H, and Series I savings bonds to pay for anything at all that you'd like, including college expenses. Every one of them is backed by the "full faith and credit" of the U. S. Treasury, and all of them represent safe, if somewhat uninspired, investments. You may use only two of them, though, Series EE and Series I savings bonds, to pay postsecondary education costs without having to pay federal income tax on the interest that you earn on your investment.

Regardless of whether you manage to avoid paying federal income tax on the interest earned on your savings bonds, you won't pay any state income tax; all interest earned on U.S. Treasury obligations is free from your state income tax.

Series EE Savings Bonds

Series EE savings bonds are your old-fashioned, garden-variety sort of savings bond, the kind your grandmother used to give you for high school graduation or your wedding. If you meet all the requirements, you may redeem them to pay for some college expenses without paying any federal income tax. In addition, they have the following features:

• They're issued at 50 percent of their face value. This means that a $100 bond costs you $50 to purchase.
• They're offered in a variety of face amounts. They range in face value from $50 to $10,000.
• They're guaranteed to reach their face value within 20 years. But they'll continue to earn interest after they've reached that value until the bond is 30 years old.
• Their issue date is always the first of a month, no matter what day of the month you actually purchase the bond.
• Interest is compounded semiannually and is paid only when the bond is redeemed. Interest rates are announced every May 1 and November 1 for the following 6-month period.
• You may cash the bond at any time, provided it is at least 6 months after the issue date for a bond issued prior to February 1, 2003, or 12 months after the issue date for a bond issued after that date. If you cash a bond that you purchased after April 30, 1997, that you've owned for less then 5 years, you'll also forfeit 3 months' worth of interest. For example, if you hold a bond for 2 years and then cash it in, you'll only receive interest for 21 months.
• You may exchange a Series EE bond for a Series HH bond at any time. You can defer the income tax on the accumulated interest in the EE until the HH reaches maturity. This can extend your tax deferral up to 20 years.
• You may not purchase more than $30,000 face value ($15,000 cash value) of Series EE bonds in any calendar year.

Not every Series EE bond is eligible for the educational expenses tax exemption. If you purchased any of these bonds before January 1, 1990, you have to pay tax on the interest even if you, and your expenses, are qualified in every other respect. Congress didn't grandfather older bonds when it enacted the new rules.