This week, Gail explains why using Savings Bonds to pay for college expenses may not be tax-free — unless you know this strategy!
Dear Gail,
My wife and I started buying EE Savings Bonds for our grandkids more than a dozen years ago. At this point, we've got $90,000 (face value) in bonds set aside for their college educations because we were under the impression that if the bonds were used for this purpose, there was no tax on the interest that they had accumulated. Now our financial advisor tells us this is not true! Apparently, this tax break is only available to parents. Can you please tell me if: 1) this is, in fact, the case; and 2) if we were to re-register the Savings Bonds in the name of our daughter (mother of our grandkids) or son-in-law, will this solve the problem?
Obviously, we're not thrilled at the prospect of paying higher income taxes when the bonds are cashed in at the time our grandchildren start college. But we're more upset that, after paying the income tax on these bonds, there will be less money available to cover their education expenses than we expected to have. From what we know now, I wish we had put the money in a 529 plan instead.
Thank you for your guidance on this,
Dan D.
Dear Dan,
Don't despair! There may be a way to rescue this situation. I'm sure you're not the only grandparents to misunderstand the "interest exclusion" on U.S. Savings Bonds (EE or I) used to pay for higher education.
As you know, the interest earned by Savings Bonds is considered taxable income. But you don't pay tax on this interest in the year it's earned. Instead, you report the interest and pay (federal) income tax on it when you cash in the bonds.
However, if you use the proceeds from Savings Bonds to pay for qualified higher education expenses, you do not have to include the interest when you report your taxable income, i.e. you can "exclude" it — thus avoiding any tax on this amount. But you must meet very specific criteria.
According to IRS Publication 970, to qualify for this tax break, the bond proceeds can only be used to pay for the qualified education expenses of: 1.) the bond owner; or 2.) his/her spouse: or 3.) "a dependent for whom you claim an exemption on your tax return." In other words, your relationship to your grandkids isn't what matters; it's whether or not you can legally claim them as dependents.
If you and your wife were raising your grandchildren, you would certainly meet this requirement. However, it sounds as if they're being raised by their parents, so they are the only ones entitled to claim the children as dependents.
Furthermore, the owner of the bond has to be at least 24 years old when the bonds are purchased.
There are also income limits that further constrain who is eligible for this tax break. This year, if you are married or a "qualified" widow(er) and claiming the Savings Bond exclusion, your "modified adjusted gross income" (MAGI*) cannot exceed $89,750. You can exclude a declining portion of the interest until your MAGI hits $119,750, at which point you lose it entirely — meaning all of the interest accrued on the bonds is considered taxable income. The income limit for all other taxpayers is $59,850, with the exclusion phased out at a MAGI of $74,850.
But bear this in mind: the interest received when you cash in Savings Bonds will be added to your other income. So someone who wants to use the proceeds from these bonds in order to pay a dependent's college expenses has to be careful about how many bonds are redeemed — cash in too many and you run the risk of pushing your income over the allowable limit!
Another quirk is that if you're married, you have to file a joint tax return. "Married filing separately" automatically disqualifies you for the Savings Bond tax break.
Last but not least, the only Savings Bonds that qualify for the interest exclusion are EE bonds issued after 1989 or a Series I bond.
Is it any wonder well-meaning, law-abiding citizens get tripped up by these regulations?!
At first glance, it might seem like a good idea to simply re-register the Savings Bonds in the name of your daughter or son-in-law, i.e. one of the parents. By this line of reasoning, you might conclude that when mom or dad cashed in the bonds to pay college expenses for one of your grandchildren (their child), they would be able to claim the interest exclusion, since they'd be using the money for one of their "dependents."
But you'd be mistaken.
First of all, changing the owner of the bonds is considered a taxable event: you would have to pay income tax on the interest that accrued during the time you owned the bonds. According to Steve Meyerhardt, a Savings Bond expert in the Treasury Department's Bureau of Public Debt, "You can't get rid of the tax liability on the interest earned from the date the bond was purchased by transferring it to a new owner."
Furthermore, changing the name on the bonds is considered a gift — from you to the new owner, i.e. your daughter or son-in-law. If the amount of this gift exceeds $11,000, you — not the new owner of the bonds — would be liable for gift tax.
Even if you were willing to accept the tax consequences, Meyerhardt said the bonds still wouldn't qualify for the interest exclusion because the law requires that the person claiming the exclusion must be the original owner of the bonds.
While it won't help in your particular situation, Dan, Meyerhardt suggested an interesting strategy for grandparents who are determined to use Savings Bonds as a college savings vehicle: When you purchase the bonds, name your grandchild as the "owner" and a grandparent as the "beneficiary." You can specify that you want the bonds sent to you, the grandparent, allowing you to retain control over when they're redeemed.
When the grandchild reaches college age and needs the money to cover educational expenses, that's when you give him/her the bonds to redeem. Because the child wasn't age 24 when the bonds were purchased, he/she does not qualify for the income exclusion, meaning the child will have to report the interest on the bonds as income and pay the tax due. However, at least grandma and grandpa won't get stuck with the tax bill. And the child could also be in a lower tax bracket.
Thus, while the owner/grandchild would have to file a tax return and report the interest on the Savings Bonds, in all likelihood they will qualify for the exclusion and avoid taxation on this amount.
(Don't worry about the child being too young to cash in the bonds. Generally, an individual has to reach the "age of majority" in their state before they can legally own and control investments such as stocks, Treasury bonds, mutual funds, etc. Depending upon where you live, this is generally age 18 or 21. Savings Bonds, however, are an exception. According to Meyerhardt, the law says a child can make transactions (invest in and redeem) Savings Bonds "when they're old enough to sign their name. (That's generally interpreted as around 12 to 13 years old.")
The problem, of course, is there's no guarantee the little darlings will actually use the money for college.
But back to your situation, Dan ...
As I said, changing the registration on the bonds you've already purchased in your name will trigger income and possibly gift tax. Why do this when you can completely avoid all nasty tax consequences?
Joe Hurley is a CPA with a Web site devoted to 529 college savings plans. He suggests you open a 529 account and fund it with the proceeds from the Savings Bonds. Name yourself as the owner of the account and either yourself or your spouse as the beneficiary. (Don't panic, grandpa. We don't expect you to enroll in grad school! Just read on.) As you probably know, 529s are free from federal income tax as long as they are used for qualified expenses, however, state taxes may apply. Also, any withdrawals of earnings not used to pay for qualified higher education expenses are subject to taxes and penalty.
By law, contributions to a 529 plan must be made in cash. This means you'll have to redeem the bonds. But, according to Hurley, "A contribution to a 529 plan that names the contributor, his/her spouse, or a dependent as the beneficiary is treated as a qualified higher education expense for purposes of the bond interest exclusion." In other words, in the eyes of the law, Savings Bond money rolled into a 529 plan meets the "usage" test and can qualify for the same tax break as using the money to pay actual college expenses. The result is that you avoid income tax on the interest!
The key is to manage the amount of Savings Bonds you redeem each year so that you can keep your MAGI below the income limits.
As you may know, one of the special privileges of owning a 529 plan is the power to change the beneficiary of the account. Once the Savings Bond money is invested in "your" 529 account, Hurley says all you have to do is change the beneficiary to one of your grandchildren. Or, you could transfer "your" 529 money into separate accounts for each grandchild. Either type of transaction is requires minimal paperwork.
When you change the beneficiary of a 529 plan to a family member who is in a younger generation (grandparent-to-grandchild, for instance), you can run into gift tax issues — but only if you transfer more than $55,000 to the new beneficiary. That's because under a unique provision in the tax code, in a single year an individual can contribute up to $55,000 to a 529 plan on behalf of someone else — 5 times the annual gift tax-free amount of $11,000.** By law, you have to wait 5 years before giving the beneficiary any additional gifts. This special gifting advantage is only available in conjunction with 529 plans.
Provided you keep this in mind when you transfer money from "your" 529 account to those of your grandchildren, you should be able to avoid gift taxes.
Once the money is in 529 accounts with your grandkids as beneficiaries, you, as the owner of the accounts, have complete control over when withdrawals are made and what they're used for. If one child decides not to go to college or gets a scholarship, you can transfer his/her money to the account of a sibling, or certain other family members. And, provided it's used for qualified higher education expenses, there is no federal income tax on money withdrawn from a 529 plan.
To re-cap, by utilizing this strategy, you can avoid: a) income tax when you redeem your Savings Bonds; b) gift tax when you change the beneficiary to your grandkids; and c) capital gains tax when withdrawals are eventually made. One more point: if you select a 529 plan that does not impose an age limit, no matter how old your grandchildren are, they will never get control over the money in their 529 accounts unless you decide to transfer ownership to them. Another advantage of using a 529 plan instead of Savings Bonds in the child's name is that a 529 is not considered an asset of the student and will have little, if any, negative impact on the child's chances of qualifying for financial aid.
I don't know about you, but I just love happy endings!
Gail
*The IRS explains that your "modified adjusted gross income" is your adjusted gross income — including the Savings Bond interest — with certain additional items added back in. These amounts include deductions you took for tuition and fees that you paid, student loan interest, the foreign housing deduction, and amounts excluded from income (when you calculated your taxes) such as income from Puerto Rico, and the foreign earned income exclusion.
**While contributions are generally excludable from contributor's gross estate, if the contributor dies during 5-year period, amounts allocable to years after death are includible in contributor's gross estate. Consult your tax advisor.
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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.
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