Updated: May 3, 2013 12:14PM
Originally published: November 19, 2002
Last week I warned of the dangers in owning bonds. This week, I’ll make an exception. That’s because the Illinois College Savings Bonds program is having another sale of tax-free bonds that carry a bonus for holders who eventually use the money to pay for college in Illinois.
With the stock market uncertainty casting a shadow on other investment plans, there’s certain to be more interest in these municipal bonds that are designed in a series to mature in the years that your child or grandchild will need the cash for college. In the meantime, they accrue a fixed rate of interest that is exempt from both federal and Illinois income taxes.
How college savings bonds work
College Savings Bonds work much like U.S. Savings bonds. They’re sold at a discount from face value, and the interest builds up over the years. At maturity, the holder receives cash for the full face value of the bond.
The purchase price is a discount from the face value of $5,000. Thus, you would pay $4,500 for a bond that will mature in five years. That discount represents an interest rate of 2.75 percent. Before you scoff at that low rate for five years, consider the tax implications. If you’re in the 31 percent federal tax bracket (plus 3 percent state tax bracket), you’d have to get a comparable yield of 3.41 percent in a CD to do better than the tax-free 2.75 percent.
Longer-term bonds carry an even higher yield. For example, a 10-year Illinois College Savings Bond might have a purchase price of $3,650. That implies an interest rate of 3.25 percent. And the individual in the same tax bracket would have to find a 10-year taxable bond paying 4.9 percent to beat this deal.
The 20-year College Savings Bond is expected to carry a 4.25 percent interest rate, which translates into a 6.44 percent taxable yield.
The actual yields for this series of bonds have not yet been determined, and they might even be slightly higher, depending on market conditions when the bonds are priced Friday.
Anyone can buy these Illinois College Savings Bonds, just to get the safety of the state’s AA bond rating on a very competitive investment. Retirees who don’t need current income could find them attractive, for example. And if you buy them to finance a college education and your child decides to attend an out-of-state school, you’ll still get the face-value cash at maturity to use for tuition.
Investors who use the proceeds to pay for Illinois college or university tuition get a special deal. Families who use maturing bonds to pay for college expenses at Illinois schools will receive an additional $20 for each year the bond is held. So if you buy a 20-year bond, you’ll get an additional $400 when you use it to pay for your child’s education.
Diversify, even in college savings plans
Over the last few years, every investor has learned the benefits of diversification. Those principles apply to college savings, as well. Stock-based programs like the Illinois Bright Start 529 Plan certainly belong among your college investments--especially if you have 10 years or more before college begins. But the College Savings Bonds, as well as the CollegeIllinois! prepaid tuition plan, have their own place in building and balancing a college fund. And that’s The Savage Truth.
Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail to firstname.lastname@example.org. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast.