Handbook: Preparing Your Child for College

Examples of Savings Instruments and Investments


Type of Instrument Definition Risk Return Liquidity Time Frame
Savings Account Accounts at a bank, savings association, or credit union Low risk because the federal government guarantees your money up to $100,000 The interest rate on most savings accounts tends to be relatively low. High liquidity-you can withdraw your money at any time. Good for shorter time periods-3 years or less.
Certificates of Deposit (CDs) CDs are notes issued by banks that guarantee payment of a fixed interest rate until a future date (the maturity date). Low risk because CDs of $100,000 or less are insured by the federal government. Interest rates are generally higher than the rates for savings accounts but lower than the rates for longer term or riskier investments. Relatively low--if you withdraw the money before the maturity date, you may pay a financial penalty. Good for medium time frames-anywhere from 6 months to 5 years.
Money Market Accounts/ Money Market Mutual Funds Money market accounts are savings accounts offered by banks, requiring a high minimum balance. Money market mutual funds are available from brokers, many banks, and directly by mail. The money that you deposit in these funds is invested in a wide variety of savings instruments. Bank money market accounts have no risk on the first $100,000 because the government insures up to this amount. Money market mutual funds are not guaranteed by the government. The interest rate for bank money market accounts is generally somewhat higher than for regular savings accounts. Rates on money market mutual funds are often somewhat higher than tor bank money market accounts. High liquidity-you may withdraw your funds at any time. However, money market mutual funds do not have to send you a check for up to 3 days. Money market instruments are best for short-term savings goals. However, because of their great safety and liquidity, many people keep a portion of their total college savings in these types of accounts.
U.S. Savings Bonds*

*If you buy Series EE bonds to pay for your child's education, the money accumulated will be exempt from state and local taxes when you cash them in if the bonds are in the parent's name and if you are a single-income tax filer and your income is below $67,250 or a joint filer and your joint income is below $108,350. These amounts are adjusted annually for inflation. IRS publication 970 provides additional details.

U.S. (EE) savings bonds are promises by the U.S. Treasury to repay the owner with interest when the bond is redeemed. Bonds earn interest for as long as 30 years. Bonds earn market-based rates right from the start. They can be purchased from banks and through employer payroll deduction plans in amounts as little as o$50. Savings bonds are completely risk-free since they are federal government obligations. The interest rate on a savings bond is usually higher than rates on savings accounts or money market mutual funds. However, it the bonds are cashed in (redeemed) before 5 years, they may pay a lower rate of interest. Savings bonds are highly liquid and can be cashed in at any bank in the U.S., not just the bank where you bought them. Good for medium and longer term savings. Although they can be cashed in any time, the maximum interest is obtained by holding them longer.
Mutual Funds These funds can be invested in U.S. Government securities or in stocks and bonds. You can purchase a mutual fund through an investment firm, brokerage house, many banks, or directly from the mutual fund by mail. Risk varies widely depending on the objectives and policies of the fund. Funds are not federally insured but your money is generally safer in a mutual fund than in a few individual common stocks because a mutual fund invests in many different stocks and bonds and thus spreads the risk over many different investments. The return on a mutual fund depends on how the market performs and on whether the fund makes good investments. Very liquid-you can sell the fund at any time. However, the amount of money you can get for the fund depends on the value, and the value changes regularly depending on conditions in the stuck and bond markets. Good for longer term investing-5 years or more.
Individual Corporate Bonds or Stocks A bond is a promise by a corporation to repay the face value of the bond, plus a fixed rate of interest, at a specific future date. Stock represents part ownership of a company. You make money on stocks either through the dividends you earn or by selling the stock at a price that is higher than the price for which you bought it. The prices of most stocks-and many bonds-are listed in major daily newspapers. Over longer periods, the price of the stock may increase or decrease. Stocks and bonds can be purchased from brokerage houses and through some banks. The stocks and bonds of good companies can be quite safe over longer time periods. However, these investments are not guaranteed by the Federal Government or anyone else. Furthermore, there are many companies that are very risky for a person to invest in. An additional risk-even for good companies-is that prices of their stocks will fluctuate widely and that an investor will have to sell at a loss. This is risky for a parent who may need to sell the stock to pay for college tuition at a time when the price of the stock is relatively low. Interest rates on bonds vary depending on the type of bond and its rating. Generally, returns are higher than on savings accounts, CDs, and U.S. Savings Bonds. The return on individual stocks can be very high depending on the dividends the company pays and the increase in the price of the stock. However, returns can also be low or negative if the price of the stock falls between the time you bought the stock and the time you sell it. Most types of corporate and all types of government bonds are highly liquid. They can be sold through a broker on any weekday that markets are open. However, some bonds can only be sold when buyers make offers. Most individual stocks can be sold almost any day; however, there are some exceptions. With both stocks and bonds, you may have to wait for up to 3 days from the date of sale for the broker to send you the proceeds. Short-term bonds are good for time periods of 1-3 years. All other bonds and common stocks should be considered as longer term investments, good for periods of 5-18 years.
U.S. Treasury Securities (Treasury Bills, Notes, or Bonds) The Treasury Department and Federal agencies issue different types of fixedincome investments such as short-term bills (13-, 26-, and 52-week bills), medium-term notes (2-10 years), and long-term bonds (over 10 years). These securities can be purchased directly from regional Federal Reserve banks, through regular banks, and through brokers. Because there are relatively large minimum purchase amounts, some people prefer to invest instead in mutual funds that invest only in U.S. Government securities. These securities have no risk since they are backed by the Federal Government. Interest rates on government securities vary with the maturity of the issue. As with other fixed-income investments, short-term issues generally have lower interest rates than longer term issues. All government securities have interest rates that are lower than corporate securities with the same maturity because the government securities are considered safer. Government securities are highly liquid and can be sold through brokers on any day the financial markets are open. Government securities have a wide variety of maturities and can, therefore, be tailored to any time frame needed by families saving for college.
Education IRAs A special type of IRA account that can only be used for higher education expenses. Parents, grandparents, or others can contribute up to $500 a year to any type of IRA-qualified savings or investment account. The account must be registered in the child's name. Only the child can use the money to pay for his or her higher education costs, or those of a sibling. These accounts have a wide range of risks since they can be invested in many kinds of savings and investment vehicles. These include CDs, money market funds, savings bonds, mutual funds, and individual stocks and bonds. Returns (as well as risks) will usually vary depending on how the account is invested. Savings instruments that pay interest will usually have the lowest returns and the lowest risk. Individual stocks and bonds or mutual funds often have higher risks and returns that reflect the relative success of the businesses or portfolio of investments. Most of the investments that are eligible for an education IRA account are fairly liquid because they can be cashed in at a bank or sold through brokers on any day the financial markets are open. The different types of investments used for Education IRAs can generally be held for any time period. However, it is usually appropriate to hold savingstype accounts for shorter periods and to invest in stocks, bonds, or mutual funds for the longer term.
State-Sponsored Prepaid Tuition Plans These state-sponsored savings plans are guaranteed to rise in value at the same rate as future college tuition costs. They are purchased by parents as lump sum or installment contracts. Their costs at the time of purchase vary with the age of the child and the level of current and expected tuition costs in each state. Upon admission to college, the accumulated value of the plan is applied to all or a portion of tuition and fees, and in some states, to room and board charges. The plans do not guarantee admission to any college but a portion of the contract value is returned if the child does not attend. Some states allow the accumulated value to be used at private colleges. These plans carry the risk that contract values will have lower returns than if a family had invested on its own rather than through the plan. This could happen if tuition were to increase more slowly than investment returns in stocks, bonds, mutual funds, or savings instruments. However, these plans could also have higher returns if tuition increases were higher than investment returns outside the plans. For a family investing in a prepaid tuition plan, the rate of return is the average annual change in tuition and fees between the date of the contract and the date on which the child enrolls in college. However, a plan's rate of return is based on averages of college costs that vary widely. Therefore, a child might attend a school that costs more or less than the average cost used to calculate the return on investment. Prepaid tuition plans are not a liquid investment. Contract holders cannot get any money back unless a child does not attend college. Even then, not all of the money will be returned. The plan's time frame depends on the age of the child when the contract is signed. States usually allow a contract to be signed when the child is born or as late as four years before expected admission.

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