The Following is an Exemplification
Afrays,
I have a co-worker who has mentioned investing in zero bonds to pay for his
kids' college educations. Not wanting to appear utterly stupid, I merely
nodded my head and went on to another topic. But I do have a 5 year old and I
would be interested in knowing more about this strategy.
John Doe in
Smithville, USA
Dear John,
Funding education expenses by the purchase of zero bonds
is a well known and reasonable strategy.
First of all, "zeros"
are issued by a variety of entities: US Treasury, US Agencies, Corporations,
States and Local Municipalities. The differences are price, credit risk, and
tax treatment. An accoutant or a good broker can explain those details. For
our purposes I will stick to US Treasury Strips/Zeros since they are widely
held to be the safest investments ( Strips are merely interest and principal
payments "stripped" from each other and they behave identically to
straight zeros). Basically, zeros have a fixed value payable at maturity
(usually $1,000), they pay no current, periodic interest cash flow, but are
purchased at a deep discount from their maturity value. For example, a US
Treasury maturing in August, 2009 at a value of $1,000 can be bought now for
approximately $391. So let's take your situation and analyze the strategy.
Since your child is 5, I will assume that you anticipate him/her beginning
college in the fall of 2009, and that you wish to have $5,000 for each of four
years of college. The key is to set the timing of maturity payments to coincide
with the timing of your future cash needs.
$5,000 Aug. 2009......Todays
Cost = $1,962(approximate)
$5,000 Aug. 2010......Todays Cost = $1,815
$5,000 Aug. 2011......Todays Cost = $1,682
$5,000 Aug.
2012......Todays Cost = $1,550
$20,000 Total ..............Total Cost =
$7,009
Obviously, if you feel you will need $10,000 per year the costs
will likewise be doubled.
In any event, the payouts are reliable as to
amount and date paid. Further, if your child were older, and therefor closer
in time to tuition needs, cost prices would be higher; if he were younger cost
prices would be lower. These instruments are "time" sensitive; the
more years till maturity - the lesser the cost for the same maturity face
amount. For more information on specific maturity pricing visit
Bonds Online,
consult listings in the financial papers, or contact any reliable broker of your
choosing.
One important fact: keep in mind that US Treasury zeros are
taxable instruments, and that even though you receive no payments until the
maturity date, the intrinsic annual principal appreciation (called accretion) is
taxable. Consult an accountant on this issue.
Also, even though the
maturity value is fixed, if you should decide to sell your zeros before maturity
you could suffer a market risk loss (or profit). That is to say, if interest
rates go up after your purchase and you sell, you will take a loss; if interst
rates have gone down you could have a profit. Interest rate predictions are
difficult, if not impossible, for the average investor so this strategy works
best for the individual who intends to leave it alone and let it grow.
If
you are one of the fortunate few who knows, or thinks he knows, which college or
university your child will be attending, you might want to check with that
institution and inquire as to whether or not they operate a formal program in
which they accept prepayment of tuition in zeros. Many schools have such
programs; each with its own set of criteria and unique format. It's worth
looking into.
As you may have noticed, the same mechanics can work well for
a retirement account, but that's another issue.
Good luck,
AFRAYS
Free Home Pages