Saving for education is a long-term investment. The more you save, the less you’ll need to borrow or seek from other sources. To encourage greater savings for higher education expenses, federal and state lawmakers have developed innovative programs throughout many years. As you consider the following, keep in mind that the more quickly you earn a return on your investment, the higher the level of risk. Know your risk tolerance so that you can feel comfortable with your decisions.

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U.S. (Series EE) Savings Bonds

U.S. Savings Bonds are promises by the U.S. Treasury to repay the owner with interest when the bond is redeemed. Bonds can earn interest for as long as 30 years, and interest rates are higher when held five years or more. You purchase bonds for half the face value price; denominations are as low as $50 for a $100 bond. These bonds are exempt from state taxes depending on your income level when used to pay for tuition. Income limitations apply. Savings bonds are backed by the federal government.

U.S. Series EE savings bonds issued after 1989 or Series I saving bonds are another tax-advantaged way to save for college.

Advantages

Backed by the full faith and credit of the United States government, the interest from these bonds is tax-free if used for qualified higher education expenses. Also, interest on Series EE and I savings bonds is usually exempt from state and local taxes.

Disadvantages

In 2005, the full interest exclusion is only available to married couples filing jointly with modified adjusted gross income of less than $91,850 or for single filers with modified adjusted gross income of less than $61,200. The interest exclusion is phased out if your modified adjusted gross income is between $91,850 and $121,850 for joint filers, and between $61,200 and $76,200 for single taxpayers. Regardless of your income, married couples filing separately cannot take advantage of this savings bond program. You can learn more about the Educational Savings Bond Program in IRS Publication 970: Tax Benefits for Education.

The rules for using savings bonds for education can be complicated. To learn more about using savings bonds for educational expenses, you should read the Bureau of Public Debt’s frequently asked questions on education and savings bonds or you can call the Federal Reserve at (866)-388-1776. You can call the Bureau of Public Debt toll-free at (800) 487-2663 for information on the latest rates for Series E and Series I savings bonds or at (877)-811-SAVE to learn how to buy savings bonds directly from the federal government. The Bureau of Public Debt’s Web site also provides information on the latest rates for Series EE and Series I savings bonds and how to buy saving bonds directly from the federal government.

Tax Forms

To calculate the exclusion of interest from savings bonds, see Internal Revenue Service Form 8815.

For additional information on the Education Savings Bond Program, see Internal Revenue Service Publication 970 and the U.S. government savings bond web site.

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U.S. Zero-Coupon Bonds

U.S. Zero-Coupon Bonds are sold at deep discount to face value and are available from the U.S. Treasury, some state and local governments and some corporations. The yield is determined by current interest rates. You receive a single, fixed cash payment at maturity. Bonds purchased from the U.S. Treasury are backed by the federal government.

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Life Insurance

A permanent life insurance policy with fixed annual premiums generally allows you to borrow against its cash value. Interest rates on such loans are usually reasonable, and many allow you to make payments on a flexible schedule. Your insurance premiums accumulate tax-deferred, and the cash value can be withdrawn or borrowed tax-free to pay for higher education. However, the amount of the outstanding loan decreases the death benefit. And, since life insurance is typically purchased as financial protection for your family should you die, borrowing against your policy may leave your family with little money to meet expenses.

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Coverdell Education Savings Account

A Coverdell Education Savings Account (ESA) is a trust or custodial account created or organized in the United States for the sole purpose of paying qualified elementary, secondary or postsecondary education expenses of the designated account beneficiary. Earnings on a Coverdell ESA grow tax-free until withdrawn to pay for qualified expenses. Total contributions for the beneficiary cannot be more than $2,000. You can open a Coverdell ESA at financial service firms and institutions. Families can claim the Hope Tax Credit or Lifetime Tax Credit in the same year they take a tax-free distribution from a Coverdell ESA, provided that the distribution from the Coverdell ESA is not used for the same expenses for which the credit is claimed. Families also can make contributions to a Coverdell ESA and 529 College Savings Plan in the same year for the same beneficiary.

Formerly known as Education IRAs, The Coverdell Education Savings Accounts, ESA, is another tax-advantaged way to pay for college. Unlike 529 plans, your investment options are virtually limitless – except for investing in life insurance contracts. You can buy and sell what you want whenever you want. They can be set them up at almost any brokerage firm, mutual fund company, or other financial institution.

Federal Tax Advantages

Earnings in Coverdell Education Savings Accounts are tax-deferred and withdrawals that are used for qualified education expenses are tax-free.

Education Expenses Covered

One advantage that ESAs have over other tax-advantaged saving options is that you can make tax-free withdrawals to pay for private elementary and high school expenses, as well as post-secondary school expenses. If private school is in the future, one option you might want to consider is saving for that expense in an ESA and using a 529 plan for college.

Contribution Limits

ESAs have two annual contribution limits for individuals:

      1. You can give up to $2,000 to anyone beneficiary assuming you meet the ESA income limits discussed below.
      2. The total of all contributions to all ESAs set up for one beneficiary cannot exceed $2,000. If other family members set up ESAs for your child, you need to check with them to make sure this contribution limit is not exceeded.

If you exceed these contribution limits, there is a 6% excise tax on excess contributions unless the excess amount is withdrawn within six months of the contribution.

Invest $2,000 a year at an annual yield of 6% from the time your child is born, and you will have a little over $61,000 in college savings when your child turns 18.

Income Restrictions

A couple filing a joint return can contribute $2,000 if their modified adjusted gross income is less than $190,000 a year. The ability to contribute is phased out for couples filing jointly with modified adjusted gross incomes of between $190,000 and $220,000. Contributions are not allowed for couples filing jointly whose modified adjusted gross income is above $220,000.

Single taxpayers will be able to contribute $2,000 if their modified adjusted gross income is less than $95,000. Single taxpayers’ ability to contribute is phased out if their modified adjusted gross income is between $95,000 and $110,000. No contributions are allowed if their modified adjusted gross income is above $110,000.

Fees, Charges, and Expenses

Fees, charges, and expenses will vary depending on the investments you choose and the institution with which you open the account. Please remember because of the fairly low contribution limits, even small annual fees or expenses could make a big difference in the value of your investment over time.

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Certificates of Deposit

Certificates of Deposit (CDs) are deposits issued by banks that guarantee payment of a fixed interest rate for a set period. The longer the term, the higher the interest rate. Early withdrawal can result in a financial penalty. The Federal Deposit Insurance Corporation (FDIC) insures amounts up to $100,000.

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529 College Savings Plan

A qualified tuition program (QTP), 529 College Savings Plans allow you to contribute to an account established for paying a student’s qualified higher education expenses. Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible education institution. Qualified expenses include room and board for a beneficiary enrolled at least half time. The Plan amount can transferred to another QTP and changes in beneficiaries are allowed so long as the new beneficiary is a family member. Families who use a qualified tuition program to finance a student’s higher education may claim either the Hope Tax Credit or Lifetime Learning Tax Credit if they meet the income limitations. Families also can make contributions to a Coverdell ESA and a QTP in the same year for the same beneficiary.

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Money Market Accounts

Money market accounts are savings accounts offered by banks that have a high minimum balance and have interest rates that are usually higher than regular savings accounts. The FDIC insures amounts up to $100,000.

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Money Market Funds

Money market funds are a professionally managed pool of money that is invested in a wide variety of savings instruments. These funds have a fluctuating rate of return over a set period and typically have higher interest rates than money market accounts. Money market funds are not insured, but funds are usually invested in safe, short-term instruments that have high credit ratings.

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Mutual Funds

Mutual funds are professionally managed pools of stocks, bonds or a combination of both. They provide a wide diversification by investing in a variety of industries without the need to invest in each individually. This spreads out the amount of risk, but mutual funds are affected by stock market and economic swings.

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Common Stocks

Each share of stock represents part ownership and a claim to the company’s assets and profits in proportion to the number of shares owned. It is a proven way to outpace inflation if investments are carefully selected and monitored. However, the stock market can be extremely volatile. Investing in a variety of industries can spread the risk and help your investments weather the ups and downs in the stock market.

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