Finding the Best Way to Save for College Costs

Q: I have a 9-year-old daughter who, I hope, will go to college some day. I am saving for her education by purchasing U.S. Savings Bonds. So far, I have about $3,500 (face amount) worth, and I estimate that this total will rise to $5,200 by the end of next year. Should I continue with this, or should I do something else to save for her college education? And what about when these bonds mature? Can I just sit on them until we’re ready to use them? I can’t afford to make any mistakes. --P.C.

A: Small savers certainly can’t go wrong buying U.S. Savings Bonds. They are absolutely safe, require no huge investment fees and can be regularly purchased in small denominations. And there’s an additional benefit that you may not be aware of: Middle- and lower-income taxpayers using their savings bonds for a college education don’t have to pay federal income tax on the bond proceeds when they cash them in. (Savings bonds have traditionally been exempt from state taxes.)

However, the real question is whether you can do just as well in a double tax-free money market account. These accounts invest in California municipal and state bonds, and although they typically carry a lower interest rate than regular money market accounts, their interest is exempt from state and federal taxes.

The issue facing parents saving for a college education is timing. You have nine more years before your daughter enters college. But U.S. Savings Bonds don’t reach their face value for about 12 years. So the proceeds from bonds you buy now can be used to finance your daughter’s senior year. And unless your daughter plans to earn advanced degrees, bonds you buy next year and beyond can’t be used for her education and won’t, under college-saver bond rules, be exempt from federal taxes.

Of course, you don’t have to wait for your savings bonds to fully mature to redeem them. Bonds earn 6.57% interest--it adjusts every six months--and bonds held at least five years are guaranteed a minimum 6% interest rate. Most double tax-free money market accounts aren’t paying higher interest rates. But then again, money market accounts have no minimum required holding period. When you want your money, you can take it.

However, you should know that money market accounts carry no federal deposit insurance. Although these accounts have performed exceedingly well over the years, there is no absolute guarantee that you will get back all that you put in.

In the end, it boils down to your personal preference. You may find savings bonds preferable because they’re harder to dip into than a money market account and will therefore keep you honest about your savings plan.

Many money market funds also have minimum deposit rules that can be prohibitive to the small saver. Also, it’s hard to beat the payroll deduction plan that many companies offer for savings bonds.

However, if your income is high, you are probably not eligible to take advantage of the tax break offered by the college saver plan.

Taxpayers filing single returns are entitled to a full tax break on the bond proceeds if their adjusted gross income is less than $40,000. Single filers with an adjusted gross income of $40,000 to $55,000 are entitled to a partial and gradually declining tax break.

Couples filing joint returns must have an adjusted gross income of less than $60,000 to take advantage of the full tax break. Partial tax breaks are available for couples with adjusted gross incomes of $60,000 to $90,000.

Don’t worry about maturity dates on your bonds. Even though Series EE savings bonds technically “mature”--that is, reach their face value--after 12 years, they will continue to earn interest for 30 years after their purchase.

Timing Is Key in Claiming Deduction

Q: I was cleaning my safe deposit box the other day and found some Financial Corp. of America stock. Then I heard that the company had gone bankrupt. Can you please tell me when it filed for bankruptcy? --J.N.

A: Financial Corp. of America filed for bankruptcy in September, 1988. Within months, the corporation’s main asset, American Savings, was taken over by federal regulators. In December, 1988, assets of American Savings were divided and placed into two separate savings institutions, both of which were taken over, with the help of federal regulators and a huge influx of federal depository insurance, by the Robert M. Bass Group.

Both institutions, American Savings Bank and New West Federal, are still operating.

Perhaps you are wondering if your recently found stock has any value? The answer is, probably not.

But before you rush to claim an investment loss deduction on your taxes, consult your accountant or tax attorney. Knowing when to claim a deduction for investment in failed thrift institutions has turned out to be more of an art than a science. Being too hasty about claiming the deduction could expose you to potential tax penalties.

At the same time, failing to exercise your deduction promptly is equally unwise. Timing is the key, and your tax professional can help you.