When saving for your child’s education, you want to make sure you are taking the appropriate amount of risk and getting the corresponding reward. In Part 3 of CollegeBacker’s series on the best way to save for college, we compare some of the safest, but low-yielding tools some parents use to save for college: Certificates of Deposit and Savings Bonds.
In the chart above, you can see an example of $100 invested at a child’s birth in three different tools: a Savings Bond, a Certificate of Deposit (CD) and a broadly diversified 529 plan. As you can see, there are vastly different outcomes and this is due to the risk-reward relationship. CDs and Savings Bonds are very safe assets, but they often do not even keep up with inflation. It is similar to putting cash under the mattress. Investing in assets like this has an opportunity cost and you are giving up the returns you could be making elsewhere.
Certificate of Deposit
A CD is a promise from a bank to pay back a certain amount of money (plus interest) after a specified amount of time. You give up your access to that cash in return for the agreed upon interest rate. The longer the time period, the higher the interest rate will typically be. For example, a one-year CD might pay around 1% interest, while a five-year CD might pay 2%. The reason people will accept these low returns is that they are FDIC insured and considered extremely safe. These moderate returns are also taxed as interest income, not lower capital gains.
Series EE Savings Bond
A U.S. Savings bond is a debt security issued by the Department of Treasury and sold to the general public to help pay for the borrowing needs of the government. Since they are backed by the full faith and credit of the United States, they are one of the safest possible investments. Since they are so safe, they typically pay very little in interest (currently 0.10%).
However, it is important to note that Series EE savings bonds are guaranteed to double in value in twenty years. So a $100 investment at a child’s birth is guaranteed to be worth $200 or when they turn 20, an effective interest rate of 3.5%. While you normally have to claim the interest as income tax, you may redeem the bond for qualified education expenses tax-free! This is why many people see them as a college savings tool. However, what you gain in safety is paid for in subpar returns and waiting for that guarantee to kick in would put many children into their junior year of college.
529 College Savings Plan
A tax-efficient 529 with CollegeBacker places you in a broadly-diversified portfolio of stocks and bonds. This diversification reduces the risk greatly, while still capturing the much higher market returns offered by stocks. The closer your child gets to their first day on campus, the less risk is taken to ensure that a small market correction doesn’t reduce your savings right when you need it most.
The moral of the story is that you want to take an appropriate amount of risk that will get you a reasonable return in a tax-efficient manner. You also want to take more risks early on and gradually become safer as college approaches. This strategy is most easily done with an age-based target date fund inside a 529 College Savings Plan.
Still have questions about saving with a 529 College Savings Plan? Send us an email us at [email protected].
This is the third of a 5-part series comparing options to save for college.
*Current rate according to Treasury Direct.gov. If held for 20 years, the bond is guaranteed to double and would thus have an effective interest rate of 3.5%.
**Reasonable expected return for a broadly diversified 529 College Savings Plan, but not guaranteed.