Redeem bonds for education tax break



Dear Joe, I have saved many bonds through the years for my son. Now that he is 18 and will be entering college in the fall, I would like to know how to go about cashing in some of the bonds for educational expenses. Can the bond money be used for books, lab fees or even housing in a dormitory? What exactly are the limits? We already have the money for tuition through the Maryland Prepaid College Trust. How do we use these bonds so that we don't have to pay huge amounts in taxes? Or will we have to pay the taxes anyway? -- Doreen


Dear Doreen,

First, you must be certain that your bonds qualify for the bond education exclusion. Make sure you can answer the following questions affirmatively:

5 key questions

• Are they I bonds or Series EE U.S. savings bonds purchased after 1989?
• Were you at least 24 when you purchased them and were they purchased in your name (not your child's)?
• Does your 18-year-old qualify as your dependent?
• Will your 2008 adjusted gross income, including interest on redeemed bonds, be less than $100,650 if you are married or a surviving spouse, or less than $67,100 if you are single?
• If married, do you file a joint tax return?

If you can answer "yes" to all of those questions, you should be eligible to redeem your savings bonds and exclude the interest from your income. However, the exclusion applies only to the extent that your bond proceeds do not exceed the qualified higher education expenses of your dependent child (or of yourself, or your spouse).

If you answered "no" to only the question about income, and your income is below $130,650 (joint) or $82,100 (single), you can exclude only part of the interest using a phase-out computation.

Unfortunately, qualified higher education expenses for purposes of the education bond exclusion include only tuition and mandatory fees -- not room, board, books, supplies or equipment.

Furthermore, your son's tuition and fees cannot be counted for the education bond exclusion to the extent they are paid from the Maryland Prepaid College Trust, or from any other 529 plan or Coverdell education savings account.

However, all is not lost. If you meet all other requirements listed above, you can increase the total qualified higher education expenses by the amount of any contributions you make this year to a 529 plan for your son.

In other words, open an account with a 529 savings program and contribute at least the amount you receive from the redemption of your bonds. The interest on the bonds now gets excluded from your income.

You will need to inform the 529 plan at the time of your contribution that the money is coming from the tax-free redemption of qualified education bonds.

When choosing a 529 plan, consider Maryland's College Investment Plan. It's a good one, and you will even qualify for a Maryland state income tax deduction.

With the money in your 529 savings program, you will be able to pay for the qualified higher education expenses (including room and board, and books, supplies, and equipment) that are not paid by your prepaid college trust fund.

The withdrawals come out tax-free to the extent they qualify under the rules for 529 plans. It won't matter if your child is still your dependent.

I suggest you wait until 2009 -- at the earliest -- before tapping the 529 account that includes the proceeds from your bond redemptions. If you withdraw from the account in the same year you redeem the bonds, the IRS may try to apply the law in such a way that your bond interest becomes taxable.

You can find more guidance (but not on that particular question) in IRS Publication 970. You will also find a lot of useful information about savings bonds and the education bond exclusion at the TreasuryDirect Web site.

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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