Tax Savings on Series EE and I-Bonds for College Funding
In recent months there has been increased interest in US Treasury savings bonds, particularly I-Bonds, because of the higher interest rates resulting from the recent spike in inflation. Investors who are pursuing these bond should ask the question, “what is the plan when they mature, or if you want to redeem them?” If Inflation ends up reverting to a more normalized historical rate, then the yields on these bonds will go down, and could even go to zero as they have in some years during the 2010’s. Given this potential issue, it’s important to have a game plan.
Clients that have accumulated a relatively significant amount in Series EE Savings bonds may have concerns about the tax implications if they cash them in, as they are taxable when redeemed. When they have fully matured, and they stop paying interest, investors may be interested in getting their money working again. One possibility is college funding. Imagine if you were a grandparent looking to help with the education of your grandchildren. Given the potential tax concerns in such a situation, we might suggest cashing in a little bit at a time each year, and subsequently opening a 529 for each grandchild with the proceeds. This can allow you to deduct the realized interest income from the bonds that are cashed in annually. There are nuances with this approach as it is important to ensure income is below certain limits to take advantage of this tax strategy. Additionally, creating too much taxable income from the interest generated can impact Medicare premiums as well. It’s also important to be aware of how the new account will be titled, as well as the gifting rules. Although there are many things to address, if done properly, this could be a good strategy to accomplish a number of financial goals for some investors.
Technically, the income exclusion rule allows for certain savings bonds to be redeemed and the proceeds to be used for qualifying higher education expenses. Expenses that qualify are tuition and fees, not room and board or books. Qualified expenses also include 529 college savings plans, Coverdell Savings accounts for oneself, a spouse or dependent. In order to take advantage of these rules the bonds must be Series EE bonds, or Series I-bond. The Series EE bonds must have been purchased after 1989. All Series I-Bonds will qualify. The owner of the bonds must have been at least 24 years old when the bond was purchased. They must be in the bond holder’s name or their spouse’s name.
There is an income phaseout, whereby being above this level precludes one from taking advantage of the income exclusion. The level is typically adjusted for inflation annually. For 2023, the phaseout begins with a Modified Adjusted Gross Income (MAGI) of $91,850 and completely phases out at $106,850. In the case of married couples filing jointly, the phaseout starts at $137,800 and ceases at $167,800. The exclusion is not eligible if you are married and still filing single. It’s important to note that when redeeming these bonds, it will create a taxable event. As a result, you should ensure that you don’t go over these levels, after the redemption of these bonds has been factored in. If you are under these income levels, you will also stay within the first tier of Medicare premiums increases which also can be increased as your income grows.
The next thing to be aware of is how the new account should be titled. The new account can be a Coverdell Education Savings account or a 529 College Savings Plan. The 529 Plan does have some advantages over the Coverdell. However, based on the client’s needs, each plan needs to be evaluated.
The new account must have the grandparent as the beneficiary. The owner doesn’t necessarily need to be the grandparent, but will make it easier to make changes to the plan in the future. Then the beneficiary can be changed over to the child at a future date, perhaps in the following year. It’s also important to be aware of the specific rules with regard to changing beneficiaries on your plan. Also note that when changing a beneficiary, gifting rules will apply. For 2023, a person is allowed to gift up to $17,000 per year without triggering a gift tax filing. Remember, if you go over the annual amount, you will be required to file IRS form 709 with your taxes. However, no actual gift tax is due. The amount simply reduces your lifetime exclusion. It’s advisable to consult with your tax advisor when planning on a larger gift in order to remain in compliance with the latest rules.
Funding of the account should be done within 60 days of redeeming the bonds. IRS form 8815 is the form that is filed in order to claim the income exclusion on the bonds that are redeemed.
Several factors must align in order to take advantage of this strategy. However, if your situation checks all the boxes, it could be another way to save on income taxes, reduce your estate and help your kids or grandkids with college expenses.