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Best gift ideas for babies' college savings

  • By Dr. Don Taylor, Ph.D., CFA, CFP, CASL,
  • Bankrate.com
  • – 06/04/2014
  • 529 Plan
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Q: My best friend Joe and I are thinking of getting some savings bonds for the children of our friend who's in the Army. He and his wife are expecting twins. I'm leaning toward Series I savings bonds. Is there a good reason to steer toward Series EE? Would it be a better idea to open an account and buy some Treasury inflation-protected securities, or TIPS, instead? We'd love guidance from the good doctor.

A: Personally, I'm a fan of Section 529 college savings plans. Where provided by one's home state, prepaid tuition plans provide a better hedge against rising college costs than other investments. If a prepaid plan isn't available, consider whether there are tax benefits to staying in state before shopping for Section 529 plans out of state. You should shop for a combination of sound investment choices and low fees.

On your question on U.S. savings bonds, I have two major concerns: taxes and college cost inflation. To qualify for the education tax exclusion, savings bonds must be purchased by the parents in their names. The twins can be named beneficiaries but not co-owners. The parents must also be over age 24 when they buy the bonds. The bond owners' tax-filing status and modified adjusted gross income influence the ability to fully utilize the education tax exclusion based on the year(s) when they cash the bonds in to pay for the twins' qualified education expenses.

To achieve tax savings, one could register the bonds in the children's names with the parents as beneficiaries but not co-owners. The interest income can be included in the child's income each year as it accrues or deferred until the savings bonds are redeemed or mature. Parents can file a federal income tax return for each child reporting the annual interest income. The intention to report annually needs to be noted on the tax returns of the children. No tax is due until the child has income in a single year equal to the threshold level that requires a return to be filed. Prior to age 18, there may be "kiddie tax" considerations in years that a child earns enough unearned income to be taxed at the parents' rate.

Why is the tax issue important? Because the current interest rate on savings bonds is low. A Series EE bond is earning 0.1 percent. The Series I bond is yielding 1.38 percent. The yield on the Series I is split into two components: a fixed portion at 0.2 percent and a floating portion to the consumer price index.

Investing in TIPS is an interesting alternative, but the taxes can't be deferred until maturity. Currently, only the five-year TIPS are priced to yield less than the inflation rate, with the 10-year and 20-year maturities priced to yield 0.63 to 1.1 percent above inflation. A Treasury Direct account allows purchases as low as $100. An alternative is to invest in a TIPS-based mutual fund. Taxes, fund minimums and annual expense ratios are concerns.

Finally, while you might want to surprise your friend and his wife with your gift for the twins, you should consider involving them in a discussion first. Since tax issues can be involved, it might be best to avoid making a unilateral decision that could conflict with their goals and plans.

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