Redeem U.S. Savings Bonds To Pay College Costs
It has become an annual rite of passage, that mass exodus of 18 to 20-somethings from towns all across the land headed off to college. For parents, it is often an emotional time, but also one fraught with concern about how to pay for it.
One savings vehicle that may be somewhat helpful in tackling this issue in certain situations is the redemption of U.S. Savings Bonds. Under the right circumstances, using savings bonds to fund college costs comes with tax savings.
As a general rule, unless a taxpayer elects otherwise, the interest on Series EE savings bonds is not taxed currently. In other words, no tax is due as the interest on the bonds accrues and bond redemption value grows.
Rather, it is as the point when the bonds are redeemed or reach final maturity that the interest received becomes taxable.
However, if certain requirements are met, an individual who redeems U.S. Series EE or Series I savings bonds to pay the cost of attending college or vocational school (for the individual, a spouse, or a dependent) may exclude all or part of the interest income that would otherwise be taxable.
As with most tax incentives, this exclusion only applies if certain conditions are met. First of all, with regard to Series EE bonds, it only applies to EE savings bonds issued after 1989.
Additionally, if married, you must file a joint return in order to qualify.
The exclusion also is phased-out for certain higher-income individuals. For 2014, the phase-out begins at $76,000 of modified adjusted gross income (MAGI) for single taxpayers and is completed at $91,000. For joint returns the amounts are $113,950 and $143,950, respectively.
The phase-out level is adjusted annually for inflation.
If the total received when the bonds are cashed is not more than the qualified higher education expenses for the year, all of the interest on the bonds may be tax-free. However, where the bond proceeds exceed the qualifying expenses, the portion of the interest allocatable to the excess isn't excludable.
The amount excluded is limited to a fraction, the numerator of which is the amount of qualified higher education expenses, and the denominator being the total redemption proceeds.
So for instance, let's say a parent receives $10,000 in redemption of Series EE bonds, consisting of $6,000 principal and $4,000 interest, and all conditions are met to otherwise exclude the inter-est. A child's qualified educational expenses for the year total $6,000.
In this example, the ratio of expenses to redemption amount is 60% ($6,000/$10,000), so $2,400 of the interest received (60% of $4,000) is excludable. The parent has to include the remaining $1,600 in taxable income. If the qualified educational expenses were $10,000 or more, all of the interest would be excludable.
There is also a way to benefit from this incentive even in years when no college education expenses will be incurred. This is because you can use the proceeds to fund contributions to a Coverdell education savings account or a qualified 529 plan, where the funds can be invested and continue to grow on a tax-free basis.
As long as eventually used for qualified education expenses, the earnings will forever be tax-free. To qualify, the funds must be deposited into the Coverdell account or 529 plan within 60 days of redemption and in the same tax year as the redemption.
Some final (but important) things to know:
The exclusion applies only to bonds purchased by an individual after having reached age 24. It does NOT apply to bonds bought by another individual (other than a spouse).
Therefore, grandparents and other relatives who sometimes buy savings bonds as gifts for children may want to give cash to the parents to buy the bonds in their own names. That way, if the bonds are redeemed to pay for a child's education, the exclusion may be available, depending on the parents' income situation at that time.
Also, at tax reporting time, you will be required to fill out and file with your return Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989. You will re-ceive a Form-INT from the redeeming institution reporting the interest as taxable, so Form 8815 is necessary to show the IRS why you should not have to pay tax on this interest.
