You can also purchase government-backed bonds — Series EE and Series I bonds — that earn tax-free interest income as long as the bonds are eventually used to pay for qualifying college and graduate school expenses. The U.S. government guarantees both bond types, so you have almost no risk of losing money; however, interest rates will be lower than most investment alternatives. Qualified college and graduate school expenses include tuition and mandatory fees for a degree-granting college or graduate school or any school eligible to disburse federal financial aid. (See fafsa.ed.gov for a list of qualified schools.)

Series I bonds increase in value based on the level of inflation measured by the Consumer Price Index (CPI), plus a return over inflation, while Series EE bonds are guaranteed to at least double in value within twenty years — which equates to a 3.5 percent minimum annual return.

To purchase these bonds and take full advantage of the federal tax breaks, you must be at least 24 years old and have a modified adjusted gross income (MAGI) below $63,100 (for 2006). If your MAGI falls between $63,100 and $78,100 when you cash in the bonds, you will receive a partial federal tax deduction. You can purchase up to $30,000 of each kind of education savings bond each year. They can be purchased through most brokerage firms or direct from the U.S. Treasury Department in denominations as low as $25.

Local and state governments do not impose tax on education savings bond gains. You are required to hold Series I and EE bonds for at least 12 months. If for any reason you sell the bonds within five years of original purchase, you will lose the most recent three months' interest paid on the bonds. Finally, education savings bonds can be transferred tax-free into a 529 savings plan, but you still forfeit the most recent three months' interest if you redeem the bonds within five years of their purchase.