Thinking of cashing in those savings bonds junior received from his grandparents to pay for college? Don't assume you can exclude that interest from your taxable income. The rules are very strict, and it is actually hard to qualify that interest as excludable.
There are four requirements that must be met before the interest can be considered potentially excludable:
- The bond must be a Series EE or Series I bond issued after 1989.
- The named owner (not the purchaser) must have been at least age 24 on the first day of the issue month.
- The qualifying educational expenses must be incurred by the owner, his or her spouse, or a dependent child claimed on the owner's tax return. Qualifying expenses include tuition at postsecondary institutions that meet the standards for federal student loan programs. Room and board, books and other miscellaneous expenses do not qualify.
- The original owner of the bond must be the parent or the parent and his or her spouse. The dependent child may be the beneficiary of the bond, but cannot be listed as an owner or co-owner. Additionally, if the owner is married, they must file a joint tax return.
Even if all four of these requirements are met, then there is an income limitation that will come into play.
Beginning in 2012, the Treasury stopped issuing paper bonds and now only issues electronic bonds through treasurydirect.gov. Paper bonds can be converted to electronic bonds using the Treasury's SmartExchange program at its website. There are some differences in the registration options available for paper and electronic bonds.
The purchaser of the bond is not the owner unless named as the owner or principal co-owner. Savings bonds can be issued with one owner and a Payable on Death beneficiary, or with two co-owners, but never both. The bond may have the purchaser's Social Security number or the owner's, or the co-owner's or even the beneficiary's. The Social Security number is only used for tracking purposes if the bond is lost or stolen, it does not determine who is taxed on the interest.
For paper bonds, the principal co-owner is the one who purchased the bonds or received them as a gift or inheritance. The registration uses "or" between the names. Electronic co-owned bonds are issued as primary owner with a secondary owner. Only the primary owner has any rights to the bond, but may give the secondary owner various rights.
Often, bonds are purchased as gifts for children, and the child is the listed as owner or co-owner. Either case disqualifies the bond's interest from being excluded under the Educational Savings Bond Program. The parent must be the original owner of the bond and the only co-owner allowed is their spouse, if married. The child may be listed as a beneficiary.
If the bond was issued with the child as owner or co-owner, your client can request a reissue showing the parent as owner provided the child's funds were not used to purchase the bond. For both electronic and paper bonds, the request form is available online at treasurydirect.gov. It must be signed by the original owner or both co-owners (children of a certain age can sign) and their signatures must be witnessed and verified by an official of a financial institution. The form and the paper bonds, if any, are then mailed in and will be reissued into electronic bonds.
It is important to be clear that the reason for the reissue request is that an error was made at purchase, and not that the current owner is giving away the bond. That would be a taxable event to the current owner.
Assuming your clients have met the above requirements, there is yet another gauntlet to pass before they can exclude the interest from these savings bonds, the modified adjusted gross income test. The calculation starts with the adjusted gross income, including the savings bond interest, and adds back student loan interest deduction, tuition and fees (Form 8917), and domestic production activities deduction (Form 8903).
For singles, head of household or qualifying widow(er), no exclusion is available if the modified adjusted gross income is more than $93,150. For married couples filing jointly, the upper income limit is $147,250. Phase out of the exclusion begins at $77,550 and $116,300 respectively. The actual calculation subtracts any nontaxable educational benefits such as scholarships from the qualified higher education costs. This net cost is then compared to the total proceeds from the redemption of eligible savings bonds (principal and interest). If the net cost is greater, all the interest may be excluded. If the net cost is less, there is a calculation on Form 8815 to calculate the proportion of the interest that may be excluded. This form must be included with the tax return to exclude the interest.
Even if it appears that the parents won't be able to exclude the savings bond interest, don't assume the child should redeem them. Full time students up to age 24, who do not have earned income equal to at least 50% of their own support will be subject to the Kiddie Tax. The 2017 Tax Cuts and Jobs Act will make the Kiddie Tax even more expensive beginning this year. Unlike prior years, a child's unearned income over the $2,100 limit will be taxed at the highly compressed trust tax rates, rather than at the parent's rate. This means that any ordinary income over $12,500 is taxed at the top rate of 37% and that capital gains for the same child would be taxed at 20%.
Excluding the interest on Savings Bonds to pay for college was one of the selling points for buying these bonds in the first place. Too bad so few read the fine print on the actual requirements.
Helen Modly, CFP, CPWA, is a wealth advisor with Buckingham Strategic Wealth, a fee-only registered investment advisor. The opinions in this article are the author’s own and may not reflect the opinions of Buckingham Strategic Wealth or Morningstar.com. The author may be reached at email@example.com.