College bonds: a taxing Catch-22
Dear Joe, I have a daughter in college and have Series EE bonds that were supposed to be tax deductible if she uses them for college. She will be a junior in the fall and needs money for tuition. The bonds are in my name. She is now 22. How do I cash the bonds and avoid having to pay for the interest if the money is going to her college education but I cannot use her as a deduction? She files her own returns now. Help. -- David
In order to take advantage of the education tax exclusion on U.S. savings bonds, you must clear several hurdles. One requirement is that the college student be the bond owner, the bond owner's spouse or the bond owner's dependent. If you no longer claim your daughter as your dependent, her college tuition payments cannot be used toward the education exclusion, and the interest earned on your EE bonds will be subject to federal income tax in the year of redemption.
You should double-check your daughter's dependency status by reviewing IRS Publication 17. If your daughter fails to provide more than one-half of her own support and is a full-time college student under age 24 at the end of the year, there is a good chance you are eligible to claim her as a dependent. Beware, however, in many situations, the combined taxes of parents and child will be lower if the child can claim her own exemption, even if it means not being eligible for the education exclusion on bonds.
Another consideration to keep in mind is how much tax benefit you stand to gain with the education exclusion. If you or your daughter claims the American Opportunity Credit, also known as the Hope Credit, or the Lifetime Learning Credit, the tuition and fees used to generate the credit cannot be used toward the education exclusion on bonds. Expenses also must be reduced to the extent that you are taking distributions from a 529 plan or Coverdell Education Savings Account to pay your daughter's college costs.
Here's an example: The parents own $10,000 worth of qualifying U.S. savings bonds, that is, they are EE or I bonds issued after 1989 to someone at least 24 years old before the bond's issue date, and they are redeeming those bonds to pay their dependent daughter's college tuition and required fees. We'll assume those fees to be $10,000. The bonds consist of $7,000 in principal and $3,000 of accrued interest. If the parents' modified adjusted gross income is below the phase-out range of $104,900 to $134,900 for joint filers in 2009, the redemption is reportable on Form 8815 and the interest income escapes tax.
However, if the parents or daughter claim the $2,500 American Opportunity Tax Credit, the expenses that can be counted toward the bond redemption decrease from $10,000 to $6,000 because it takes $4,000 in tuition and fees to produce the $2,500 credit. Now only six-tenths of the bond interest, $1,800, is tax-free; the other four-tenths, or $1,200, is taxable on the parents' Form 1040.
Some experts suggest there may be another way around the dependency dilemma. The tax rules allow you to take advantage of the education exclusion if, assuming they are qualifying bonds and your income is below the income phase-out, you redeem your bonds and contribute the proceeds to a 529 plan that names you or your spouse as beneficiary. Once the funds are in the 529 plan, the account beneficiary can presumably be changed to your daughter and distributed tax-free for her college expenses even if she is not your dependent. However, this apparent loophole may be challenged by the IRS, and you should obtain the advice of your tax professional before attempting it.