Savings Bonds vs. 529 Plans: Which Is Best for College Savings?

It was a rite of passage for many kids: On special occasions, a relative would hand over a card with a savings bond tucked inside. For years, this was the go-to way for parents, grandparents and other relatives to contribute to a child's college fund.

Now, many of these kids are grown and may be thinking about buying or gifting savings bonds of their own. "It's what our parents did," says Beth V. Walker, founder of the Center for College Solutions and author of "Never Pay Retail for College." "It's a carry-over."

However, while bonds still come with perks and tax advantages, financial experts say there are better options nowadays. "The big difference now is that the investment landscape is a lot different than it was 30 years ago," says Elizabeth Sheehan, financial advisor and director at UBS Financial Services in Chicago. That changing landscape has led to savings bonds losing some of their previous luster.

[See: How to Talk to Millennials About Money.]

Why Bonds Are No Longer King

Keith Bernhardt, vice president of retirement and college products for Fidelity, says savings bonds were popular for good reason. At one time, they were the only investment vehicle offering a tax incentive for college savings. Under certain circumstances, the interest earned on bonds redeemed for qualifying education purposes was tax-deductible. "Also, bonds were paying a fair amount of money, used to be 5 percent or more," Bernhardt says.

Overall, bonds provided a safe, predictable way to invest money for college. However, not everything about savings bonds is ideal. "There are some hoops you have to jump through for the tax advantage," Bernhardt says. Only Series EE and I bonds purchased by an adult age 24 or older after 1989 are eligible for the tax deduction. Plus, there are income restrictions, and the list of qualifying education expenses is narrow, covering tuition and fees but not room and board, books or computer costs.

There is also the difficulty in tracking and redeeming savings bonds. Although new savings bonds are issued electronically, old paper bonds must be redeemed at banks. "A lot of people are trying to keep it simple," Bernhardt says, and savings bonds seem anything but simple.

529 Plans: the New Savings Bonds?

With interest rates for new Series EE savings bonds a paltry 0.10 percent, a newer way of saving for college is catching the eyes of parents. 529 plans were introduced in 1996 as a way for people to take advantage of market rates while saving for college. Money deposited into a plan can be placed in stocks, bonds or other investments. Like savings bonds, the gains are tax-deductible when used for qualified education purposes. However, those purposes are defined by a list of items more expansive than those associated with bonds. What's more, many states have their own deductions for contributions made by their residents.

"The fact that they're sponsored by states confuse people," says Peg Creonte, senior vice president of Ascensus College Savings. While each state has a plan they administer, people are free to choose and invest in whichever 529 plan they prefer. Federal tax deductions apply regardless of which state's plan is used, although states may only allow income tax deductions for their own plan.

[See: 6 Essential Questions to Ask Before Choosing a 529 Plan.]

For those who want to provide the gift of college savings, 529 plans are working to make it easier to make a contribution than to give a savings bond. Many plan administrators have set up websites where parents can direct grandparents, relatives and other friends who wish to make a contribution. "We've seen a huge increase in usage in our gifting platform," Creonte says. She notes that Ascensus went from $20 million in contributions made through its Ugift website in 2012 to $100 million in 2016.

Tax Advantages Aren't Everything

While getting a tax deduction is nice, that shouldn't be the only consideration when it comes to college savings. "If I were hanging out in the delivery room, I would tell people to put money where it's not going to hurt them in the financial aid formula," Walker says.

Walker says people should work to lower their expected family contribution to maximize financial aid from both the government and higher education institutions. That may mean foregoing the tax benefits of a 529 plan, which is counted as an asset in the financial aid formula, and instead looking for "financial aid invisible wrappers," as Walker calls them. These include three main assets not included in the expected family contribution calculations:

-- Cash value from a life insurance policy.

-- Money in retirement accounts.

-- Home equity.

Families hoping to lower their expected family contribution may find that rather than setting aside college savings, it may make sense to pay down a mortgage and then tap into the equity to pay tuition. Another option would be to make contributions to a Roth IRA and then use money from that account for college expenses. Since Roth accounts are funded with after-tax dollars, the principal amount in those funds can be withdrawn early without penalty.

The decision about whether to pursue the tax advantages of a 529 plan or focus on a nontraditional way of paying for college depends largely on a number of factors ranging from a family's overall financial situation to their other big life goals. The same can be said for what people who have already invested in bonds should do.

[Read: You Didn't Put Money Away for Your Kid's College Fund. Now What?]

"If someone has a big stack of bonds, the first thing I would do is recommend they talk to a financial advisor and a tax planner," Sheehan says. Those bonds could be rolled over to a 529 plan or cashed in to be used for a different savings strategy. However, either option could have tax implications and affect a household's overall financial picture. Consulting with the professionals can help identify the right course of action to maximize the value of the money.