A common college savings solution, 529 plans allow tax advantaged savings for college but only if the funds are used for education; and your money must be allocated among the funds allowed in the state’s plan, the account must pay fees to the state, and you must limit investment changes, etc. By now you are probably pretty familiar with the rules, but maybe you are less familiar with the mediocre performance at many college plans. Too, you need to keep an eye on the underlying funds – which have a habit of becoming more risky when markets are good – and can be changed by the state whenever a fund company’s contract doesn’t please the state. In short, these accounts have many pitfalls.
Call this the ‘Anti 529 Plan’. Tucked under a corner of the municipal bond market, you will find zero coupon bonds, which you buy at a deep discount, like the old government savings bonds. On maturity, the bonds mature to full par value. The difference between the purchase price and par is your yield.
Because the market prefers immediate cash flow, zero coupon bonds have higher than average yields, because all their cash flow comes at maturity. Since the bonds are municipals, your tax impact will be nothing, or very nearly nothing. Better yet, you can keep the bonds in your name, and if your child does not go to college, you can use the money yourself. No restrictions.
Zeros can be used to save for all kinds of things, but they work best for intermediate to long term goals, like college savings for a young child, or retirement savings.
There are two drawbacks to these bonds: they can be hard to find (you will need a broker to look for you, but a discount broker could do the job), and credit risk is a minor issue with some of these bonds. Stick to well rated issues in solid states, and you will be fine.
As a rough example of how these bonds work: You should be able to buy $50,000 worth of bonds due in fifteen years for a little north of $26,000. That equates to about a 4.4% tax free return every year. No mess, no fuss. Just salt them away, and you will find a pot of gold when you need it.
We usually advise that clients use this strategy in conjunction with something that offers higher returns, like stocks, but only if the runway is long. Last thing you need is for stocks to drop 20% just when you need to write a tuition check!