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How Do I Use Savings Bonds for College Expenses?

Question: I have purchased EE bonds for the past 18 years for my daughters with the expectation of using them for qualified college expenses (tax exempt was the plan). I make over $150,000 now and I think that income far exceeds the cutoff for getting the tax break. The bonds were made out in each of my daughter’s names with “or Gregory Parker” (me). Can my girls redeem the bonds as needed for college, since the bonds are in their names, with no tax implications to them or me? If not, can they redeem them at their tax rate?

– Gregory S. Parker   Fernandina Beach, Fla.

Answer: You’re right: You currently earn too much to take advantage of the savings bond education tax exclusion, which allows qualified taxpayers to exclude from their gross income all or part of the interest earned on eligible Series EE and Series I bonds issued after 1989 if that money is used for college tuition. The tax break is phased out for single filers who make between $70,100 and $85,100 and for married couples filing jointly who make between $106,650 and $136,650.

Unfortunately, your daughters will also not be eligible for the tax benefit because they did not purchase the bonds. However, since it appears the bonds were given to your daughters as a gift – and are in their names – they should be able to cash them and report the income as their own (at a lower tax rate than you), says Mel Schwarz, a partner at Grant Thornton’s tax office.

Your daughters, however, could be subject to the so-called “kiddie tax” if they are younger than 24 and receive at least half their financial support from you. That means investment income of more than $1,900 would be taxed at the parents’ marginal rate rather than at the child’s likely lower rate.  One way to decrease this tax burden is to redeem the bonds gradually each year to avoid hitting the $1,900, says Schwarz.

Since parents often underestimate how much they’ll be earning when their children are ready for college, Schwarz recommends that clients open a 529 college savings plan, which is an investment account for higher education expenses. Like an IRA, the savings grow tax-free and there’s no tax on the gains — regardless of how much the parents are earning when the money is used. Many states also provide a tax deduction or another benefit for contributions.

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