As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan-the mix of investments if you start when your child is a toddler should be different, from those used if you start when your child is age 12.
The following are often recommended as investments for education funds:
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Series EE bonds: These are extremely safe investments. They should be held in the parents' names. If the adjusted gross income of you and your spouse at the time of redemption is at or under the amount set by the tax law, the interest on bonds bought after January 1, 1990, is tax-free as long as it is used for tuition or other qualified education costs. If your adjusted gross income is above the threshold amount, the tax break is phased out. In 2016, the exclusion ($76,000 indexed for inflation) begins phasing out at $77,200 modified adjusted gross income and is eliminated for adjusted gross incomes of more than $92,200. For married taxpayers filing jointly, the tax exclusion begins to be reduced with a $115,750 modified adjusted gross income and is eliminated for adjusted gross incomes of more than $145,750. The exclusion is unavailable to married filing separately.
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U.S. Government bonds: These are also investments that offer a relatively higher return than CDs or Series EE bonds. If you use zero-coupon bonds, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don't receive it until maturity.
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Certificates of deposit: These are safe, but usually provide a lower return than the rate of inflation. The interest is taxable. These should generally only be used by the most risk averse investors and for relatively short investment horizons.
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Municipal bonds: Assuming the bonds are highly rated, the tax-free interest on them can provide an acceptable return if you're in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child's life.
Tip: Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:
Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable return equivalent. For example, if the return on municipal bonds is 5 percent and you are in the 30 percent tax bracket, the equivalent taxable return is 7.1 percent (5 percent divided by 70 percent).
- Stocks: An appropriate mutual fund or portfolio containing stocks can provide you with a higher yield than bonds at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.
