A Year-End 'Gift' From the IRS

This week, Gail suggests EE-Bonding with your kids and offers a chart to calculate your yearly sales tax.


I'm looking into investing in a 529 for my 12-year-old daughter. I've not done it to this point because of the 2010 expiration date (I have a UGMA account instead). However, I've recently found out that my state allows us to take a $2,000 tax deduction for money put into a 529 account.

I know that savings bonds can be used for college expenses (interest is tax free) with the caveats (post-1989 bonds, and income levels, I think also must file taxes married filing jointly). I also know that bonds can be rolled (cashed in and invested) into any 529 tax-free. What I don't know is if the same income and filing restrictions apply for tax purposes?

Through a company automatic purchase plan, we bought many savings bonds over the years hoping to use the proceeds for college. However, because of state taxes and our income level, the tax benefits of using savings bonds for college is gone. Or do we still have this option available by rolling our EE savings bonds into a 529 and then using the proceeds for college?

Thanks for your help!


Dear Jodi —

I can tell you’ve done a lot of homework on this! As you clearly understand, U.S. Savings Bonds are potentially an attractive way to save for a dependent’s college education, but as I wrote earlier this year, you practically need a master’s degree to avoid the pitfalls that await you if you don’t follow the rules.

In a nutshell, you can avoid paying tax on the interest earned on U.S. Savings Bonds used to pay for higher education (college and grad school) expenses provided:

—The bonds are either Series EE or “I” Bonds bought after 1989;

—The owner of the bonds was at least 24 years old when the bonds were purchased;

—They are being used to pay the college expenses of either the bond owner, his/her spouse, or a dependent [claimed on your income tax return];

—The proceeds are used for “eligible” higher education expenses. This includes tuition and fees but [not] room and board;

—You cash in the bonds during the same year you incur the expenses;

—You meet the income limits.

According to Steve Meyerhardt in the Treasury Department’s Bureau of Public Debt, your “Modified” Adjusted Gross Income (MAGI) is what counts. (This is your AGI with certain items added back in. Visit http://www.publicdebt.treas.gov/sav/sbedfaq2.htm for details.) The 2004 income limits are:

Married filing Jointly [or] Qualifying Widow(er) MAGI

Interest completely excluded: $89, 750

Interest partially excluded : $89,751- 119,750

All other filing statuses

Interest completely excluded: $59,850

Interest partially excluded: $59,851- 74,850

Rolling the proceeds of qualifying savings bonds into a Section 529 college savings plan is also considered an “eligible” use and is tax-free provided you meet the other requirements.

That’s the catch. According to Meyerhardt, whether you’re cashing in the bonds to pay for college expenses or to fund a 529 plan, you have to meet the same income limits.

Since you won’t escape paying income tax on the bond proceeds (unless your income drops), you can either: 1) bite the bullet, cash the bonds in now, and invest the proceeds in a 529 plan where it can grow tax-free without income limits, or 2) hold on to the bonds and cash them in when your daughter starts college. By then, of course, they will have accumulated more interest, so your tax bill will be higher.

Frankly, I’d go for option #1, unless you’re the kind of person who can only sleep at night if their money is getting a “guaranteed” return. Besides, the state tax deduction you get might more than offset the additional income tax you’ll owe. But with only 5-6 years to go before you will need to withdraw this money, I’d opt for a relatively conservative investment mix within the 529.

Best wishes,


Dear Readers,

Just in time for the holidays, I.R.S. Publication 600 has arrived!

Earlier this month I told you that starting with 2004, you now have a choice between deducting your state and local income taxes or state sales tax when you compute your federal income tax.

This is a gift for folks who live in states that don’t have any income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. But if you live in one of the other 43 states and don’t pay a lot of state income tax, you, too, might get a bigger deduction by using the sales tax number.

Of course, since we didn’t know this law was going to pass, most of us have not been saving our sales tax receipts since the first of the year. That’s where Publication 600 comes in. The Internal Revenue Service has worked up tables for every state that estimates the probable amount of sales tax you paid this year. The amount is based on your “total available income” (which includes your Adjusted Gross Income, plus tax-exempt interest, veterans’ benefits, nontaxable combat pay, and workers’ compensation).

If you bought any “big ticket” item such as a car, major appliance, furniture, motor home, or boat, the sales tax you paid for this gets added to the general sales tax amount you get from the chart.

If you typically receive a Form 1040 package from the I.R.S., Pub. 600 will be included. If you’re burnt out on football or post-holiday sales, you can download it from the IRS website: http://www.irs.gov

There’s a simple worksheet (trust me- you only have to fill in 7 spaces) that can help you decide whether you’ll get a bigger deduction from using your state income taxes or sales taxes. You might be surprised.

This is especially true if you built or re-modeled a home this year. If you directly paid for construction materials (as opposed to paying the builder), you might find that your annual sales tax exceeds your state income tax.

Hope this helps!


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