Savings Bonds to Shed Ugly Duckling Image

Think of all those “no-brainer” investments--the ones you buy but don’t think about a lot. Certificates of deposit. Passbook savings accounts. Treasury bills.

Many people put U.S. savings bonds on that list too. Pretty boring, you probably think. But that’s a mistake, especially now. Starting next month, savings bonds will require a lot more thought, while becoming arguably the most attractive tax-deferred investment anywhere for eligible investors.

Series EE bonds purchased after Jan. 1 will become exempt from federal tax if you meet certain age and income criteria and use the proceeds to pay for the college education of your dependents, yourself or your spouse.

Even without this change, savings bonds already are one of the best and safest tax-deferred investments. They are already exempt from state and local tax. In addition, you can defer paying federal tax until the bonds mature or you redeem them--probably the most important, yet unheralded, advantage of savings bonds.

That feature in many ways makes them superior to zero-coupon Treasury bonds, which receive most of the publicity and are touted as long-term savings vehicles. That is because zeros, unlike savings bonds, are taxed annually even though you don’t receive the interest until they mature (meaning that you are taxed on money you don’t even have!).

What’s more, the interest on savings bonds, while competitive, also enjoys a sort of insurance policy against falling rates. The annual rate can’t go any lower than 6% if you hold them at least five years. But there is no limit to how high they can go, because rates are variable and pegged to 85% of the five-year Treasury note rate. So if we have another round of double-digit rates similar to those of the late 1970s and early 1980s, rates on savings bonds will be adjusted upward to reflect that.

This tax deferral and interest protection makes savings bonds “probably the most attractive vehicle for someone looking for absolute certainty they won’t lose their principal,” says William F. Brennan, a partner at the accounting firm of Ernst & Young in Washington.

Now comes the latest bonus: the new tax exemption for college expenses, passed by Congress in 1988 to help ease the increasing burden of paying for higher education. That tax break can make an already decent yield on bonds too juicy to pass up.

If you are in the 28% tax bracket, for example, the current 6.98% rate on savings bonds becomes equivalent to a 9.69% rate in a taxable investment such as a CD or money market fund. That’s pretty darn good.

But getting such a tax-free yield is not automatic.

There are several conditions and complications. First, to qualify for the tax break, you must be at least 24 years old when you buy the bond. And you can use the proceeds only for college expenses of your dependents, yourself or your spouse.

The tax break also will apply only if you use bond proceeds for tuition and required fees, not for books and room and board. And it will apply only to degree programs at colleges, universities and certain vocational schools. It won’t work at for-profit vocational schools such as those teaching cosmetology, auto mechanics, secretarial skills and the like.

To keep rich folks from using savings bonds as a tax shelter, the rules also call for the tax break to be phased out if you are married filing jointly with modified adjusted gross income between $60,000 and $90,000, or if you are a single filer with income between $40,000 and $55,000. Below those levels, you get the full break and above them, you will receive no federal tax exemption.

Fortunately, those phase-out levels will be indexed to inflation, so they will rise in future years, notes Stephen Meyerhardt, manager of public affairs for the Treasury Department’s savings bond division. You’ll need that, because eligibility for the tax break is determined by your income at the time that you cash in the bonds, not when you buy them. If you hold them to maturity, that can be 10 to 12 years from now.