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I'm helping my father to decide how to best invest money for his grandchildren's educations. A previous suggestion, since the time horizon until the money is needed by the grandchildren is only 2-5 years, was to invest in CD's. Wouldn't I Bonds also be a good alternative? CD's are only paying around 7%, whereas I Bonds are currently at 7.49% and subject to increase due to the inflation indexing attached to their rate. I Bonds are tax deferred and could be tax free if used for college (though I understand they would have to be titled in the parents names). I understand their would be a 3 month interest penalty if the bonds were used before they were held for 5 years, but for the interest rate and tax advantages this penalty doesn't seem like a show stopper. Since the bonds are in the parents names, they would be less of a factor in financial aid determinations. What am I missing Fools?

Here are some potential pitfalls:

1) A 7.49% guaranteed return is very good, but I would be surprised if it is still available. The old bonds that pay off that much were priced assuming a lower inflation rate than what actually occurred. If you are actually able to get a rate this high on newly issued I bonds, please post to the board again -- I would love to know that this was the case. But I suspect that the current high rate of return is just a temporary blip.

2) Assets in the parent's name are subject to a "tax" of about 5% in the financial aid calculations. This may not sound like much, but it is 5% of the total amount, not just the interest. If the investment gains 30%, then a 5% tax on assets is the same as a 22% tax on the investment returns. So the cost of transferring the money to the parents (as opposed to leaving it in the grandparents' names), in terms of financial aid benefits, can be high. This is on top of the approximately 8% penalty (3 months' interest out of about 3 years of total investing) for early withdrawal.

The decision between CDs and I Bonds is a close one. In the past, the I Bonds were actually a much worse deal (the people who bought them were more nervous about inflation than the rest of the market, so they only earned about 3% + the rate of inflation; it turned out, for the most recent period in which the CPI was calculated at least, that the inflation hawks were right to worry), so I would be surprised if they beat CDs by any significant amount over a few years.

-- Edmund Ross
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