529s Insights

Introduction to I Savings Bonds

With such a high cost, parents, grandparents and other caregivers have been diligently looking for ways to pay those fees without having their children go into debt. And while 529 plans are a wonderful savings vehicle for college, they aren’t the only choice and they do carry some limits on flexibility.

This is where an I Series Savings Bond could be a great choice for college savings.

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What Are I Series Savings Bonds?

Like many of the Treasury’s savings bond products, I bonds are considered zero-coupon bonds. With this, interest is added back to the bond and compounded until you sell the savings bond back to the United States government. This interest is calculated in two ways. First, I bonds have a fixed rate that stays with the bond for its interest-earning life, currently 30 years. Second, the bonds feature a semi-annual variable rate that changes with fluctuations in inflation. As the Consumer Price Index (CPI) changes, so will the I bond’s interest payment. The idea behind the fixed and variable rate is that I bonds will always be beating inflation by a certain amount.

The benefit to I bonds is that as they compound their interest, investors can defer its taxes. As long as you don’t sell your I bonds, both the fixed and the variable rates remain non-taxable. Because of this feature, many investors use them as another vehicle for retirement savings, allowing them to push inflation-protected cash up to 30 years into the future.

A Solution for College

Here, I bonds offer some tax breaks for education expenses and could possibly help cover college costs in a tax-free manner.

When a parent sells an I bond, all funds – both interest and initial principal – must be used toward higher education payments for the owner, his or her spouse, or a dependent. Those payments can be used for tuition, lab and course fees, and degree-required courses. Unfortunately, room and board, books, sports and recreational activities do not count as qualified expenses when it comes to I bonds.

As long as the total proceeds from the bond sale are less than the amount of eligible expenses, savers can skip paying taxes on the accrued interest. Those tax benefits start to phase out for single taxpayers with an adjusted gross income of $93,150 or above, while for married taxpayers the adjusted gross income clocks in at $147,250.

Moreover, if the bond sale exceeds the higher education expenses, the amount of tax-exempt interest is prorated and savers will need to pay some taxes no matter what their gross income is. The Treasury Department provides this example on how it works. If you sell an I bond for $10,000 – i.e. $5,000 principal and $5,000 interest – and the qualified educational expenses are $8,000 then the taxpayer would only be able to get an interest exclusion for 80% of the interest earned. In this case, only about $4,000. You’d still owe taxes on the remaining portion.

Thanks to their tax deferral and potential tax-free status, I bonds can work well in concert with a 529 plan. You can use the proceeds from I bonds to cover tuition, while a 529 plan provides a bit more flexibility when it comes to other college expenses such as room/board and required technology. Together, they make sense. And the I bond gives you the flexibility to hold for decades to be used as a retirement or general savings vehicle as well.

Be sure to check out our 529 Insights section here to learn more about 529 plans.

How to Buy Them

There are two other caveats with buying I bonds. First, each taxpayer is only allowed to purchase $10,000 in I bonds per year. So, a married couple buying I bonds for college could save a total of $20,000. Secondly, you have to hold them for at least a year, and selling before five years reduces the amount of credited interest. They are designed to be long-term holds.

Other than that, it’s pretty straightforward to build a cache of I bonds for college savings, as well as other purposes.

The Bottom Line

Check out our state plans section here to learn more about the rules and regulations pertaining to each U.S. state.