Zero-Coupon Bonds and FSAs

This week, Gail says appreciation potential is what you need for college planning, and reminds us that Flexible Spending Accounts can be a tremendous budgeting tool.



I'm researching a variety of college savings plans for my daughters (ages 3 and 8 months). Given the recent volatility in the stock market, which is where any money in a 529 plan would be invested, buying zero-coupon bonds has been suggested since the money will be there (guarenteed) when we need it.



Dear Robert,

One of the critical concepts every bond buyer needs to understand is the relationship between interest rates and the price of bonds: they move in opposite directions.

Right now, interest rates are extremely low. In fact, they haven't been this low in 41 years. Which means that as yields have fallen, the price of existing bonds has gone up.

It's simple to understand why: if the current rate on a bond with a certain maturity is, say, 3% and I own a bond that pays 4%, then my bond is more valuable than the 3% bond. If you want to buy it because you need the income it provides, then you will pay a "premium" for this. In other words, you will pay more than the "face value" of the bond, which is generally $1,000.

But when a bond matures, the maximum it will be worth is its face value, i.e. $1,000.

And of course, when rates head higher, if you try to sell your low-yielding bond for one generating a better return, you will get less than $1,000 for it.

Zero-coupon bonds operate differently. They pay no interest until maturity. Instead, they are always purchased for less than their face value. When they mature, the bondholder receives one lump sum which consists of the initial investment plus the accrued interest. This lump sum adds up to the face value.Unless you are buying zero coupon municipal bonds, which are rare, the interest which builds up in a zero is considered "income" each year it accrues. You will pay income tax on this interest even though you never receive it until the bond matures.

This type of bond can make an excellent long-term investment when interest rates are high. That's when you can expect to get the biggest discount on a zero-bond purchase (because the discount reflects the interest rate). When rates are low, though, you can expect a much smaller discount. And you also have a greater chance of having your bond decline in value as rates rise and newer-issue zeros become available with deeper discounts (i.e. paying a higher interest rate) -- and are consequently more attractive to investors.

So, whether you are talking conventional bonds or zeros, you are not looking at much in the way of appreciation potential from an individual bond investment. And appreciation potential is what you need for college planning.

Don't assume that "all" 529 investments involve stocks. In fact, if you're worried about the stock market, there are a wide variety of less volatile choices. Depending upon the 529 you choose, you'll find everything from a money market fund, to a diversified bond portfolio, to what's called a "stable value" fund.

But, frankly, your children are so young, they ought to have exposure to the stock market. Historically, equities have provided the best return over time.

Why not put their college money on auto-pilot by investing it in a 529 plan that offers age-based portfolios? These are adjusted according to the age of the beneficiary. They start out with a heavy equity weighting while the child is young and gradually move to cash and short-term bonds as the child approaches college age.

If you invest via a 529 plan, the gains on qualfied withdrawals are completely free of federal -- and often -- state tax. In addition, you've got professional managers adjusting the portfolios to avoid the pitfalls and take advantage of the potential rewards the financial markets offer -- including those of a changing interest rate environment.

Hope this helps,



Thanks for your columns, I've learned a lot. Maybe you can help clarify something for me.

I am a federal employee. The Office of Personnel Management has recently announced the kickoff of "Flexible Spending Accounts". The gist is that we are allowed to set aside pre-tax dollars to pay for "eligible medical and dependent care expenses".

I can't stop wondering what the catch is. I think I've found it: potential interest and earnings. These accounts are non-interest earning for me, but the fund manager gets to use my money for their purposes.

So here's my question: is the FSA really as good a deal for me as it seems, or is it simply a big money-making opportunity for a financial institution somewhere?



Dear Dennis -

Boy, are you a cynic! Flexible Spending Accounts (FSA) have been in the private sector for years and they can be a very useful benefit.

An FSA allows you to specify that a certain amount of money be deducted from your paycheck and set aside in an account ear-marked with your name. You -- and only you -- can use the money in your account to pay for a variety of benefits you would otherwise have to purchase with after-tax dollars.

This includes such things as medical and dental expenses not covered by your health insurance plan (such as your co-pay), as well as child care (day care) and even elder care expenses.

The catch is that you have to decide before the year begins the total amount you want to contribute to your Flexible Spending Account. If there's any money left unused by the end of the year, you lose it. So you need to estimate carefully.

There is a tremendous benefit of being able to pay for these things with PRE-tax dollars. In a nutshell, you need fewer dollars to cover the same expenses.

Here's what I mean: Suppose you know that the prescription allergy medicine your spouse gets refilled monthly costs you $40/month out-of-pocket, your child's day-care runs $2,000/year and the orthodontic work your eldest child needs is going to run $1,200. In other words, you know ahead of time that you're going to face $3,680 worth of bills in the year ahead.

If you're in the 30% tax bracket, on an after-tax basis, this means you've got to earn $5,257 in order to pay for these expenses with your take-home pay. ($5,257- 30% tax = $3,680)

However, if you take advantage of your flexible spending account, these same expenses will only cost you $3,680 because the money is set aside before taxes are subtracted -- a savings of $1,577!

Sam Van Why, a professor at the College for Financial Planning, says provided the plan being offered federal employees falls under Section 125 of the Tax Code, there are stringent rules that must be followed with regard to what is done with the FSA money collected each payday. But in light of the fact that the money has to be available when participants need it, it has to be kept in very liquid investments.

But the key for you to understand is that you have access to the full amount earmarked for your FSA before you have actually contributed all the money!

Using the above example, let's say that at the start of the year you sign up for a flexible spending amount of $3,900 -- large enough to cover the bills you know you're going to have, as well as a little extra. Each month $325 will be deducted from your paycheck toward this total.

In January, you pay for half a year's worth of child care, plus the full orthodontist bill. You make a withdrawal of $2,200 from your flexible spending account. That's right: so far you've only contributed $325, but you have the use of the full amount in your FSA from the beginning of the year!

"If you use up your whole FSA amount by September, you're getting the benefit of the money before you even contribute it," says Van Why. "And if you leave your employer, you never have to contribute the balance."

Don't be so negative. Stop thinking there's someone trying to pull a fast one on you at every turn. Sign up!



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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.