Family finance: Cashing in bonds early for 529 plan

Lynn Brenner | Family Finance

April 13, 2008

Our daughter is 8, and we have a 529 savings plan as a college fund. We also are holding several savings bonds for her education. Can we cash in the bonds early and transfer the proceeds - principal and interest - to the 529 plan without paying taxes on any gain so far? L.S., East Northport

Yes - but only if you meet a list of conditions laid down by the Internal Revenue Service.

To qualify for a tax exclusion on all the bond interest, you must have modified adjusted gross income of less than $98,400 if you're married filing jointly, or less than $65,600 if you're single. Above those amounts, your eligibility for a tax exclusion starts to phase out, and you can't exclude any of the interest from taxes after your MAGI is more than $128,400 if you're married filing jointly or more than $80,600 if you're a single taxpayer.

Your MAGI is the amount on line 38 of Form 1040 - and for purposes of this calculation, it must include the savings bond interest that you're hoping ultimately to exclude. You must also add back into the amount on line 38 a number of other exclusions and deductions, among them the foreign earned income exclusion and the deduction for student loan interest.

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There are other conditions you must meet, too. The bonds must be either Series EE bonds issued since 1990, or Series I bonds. You must have been at least 24 years old when you bought them. And although the bonds are to be used for your child's education, they must be registered in your name and/or your spouse's name. (Your child can be listed as the beneficiary, but not as an owner or co-owner).

You'd also have to meet all the above conditions to escape tax on the bond interest if you were to spend this money on your daughter's college expenses instead of transferring it to a 529 plan.

The bottom line: The tax exclusion on savings bond interest that's used to pay for college is not nearly as good a deal as it sounds. In fact, people who earn enough to afford to save for college in the first place usually earn too much to qualify for the savings bond education tax exclusion.

Even if you qualify for this tax exclusion when you first buy the bonds, you should hope you'll earn too much to claim it by the time you're paying for college. (The income ceiling goes up every year, but very slowly. With any luck your salary will rise faster.)

By contrast, all your 529 plan earnings are tax-free when spent on college expenses, regardless of your income.

Bear in mind that all 529 contributions are a gift to your daughter. Together, you and your wife can give her up to $24,000 a year without having to file a gift tax return. (Each taxpayer can give up to $12,000 a year to an unlimited number of recipients without owing any gift tax or having to file a gift tax return.)

What if these bonds are worth $24,000 and are registered only in one parent's name? Then that parent must file a gift tax return, but no tax will be due, says Alan E. Weiner, senior tax partner at Holtz Rubenstein Reminick in Melville. The reason: Each taxpayer can give away up to $1 million over his or her lifetime, in addition to the unlimited $12,000 annual gifts, without incurring a gift tax.

Clarification: My March 9 column explained that the tax-deferred accrued interest on E bonds becomes taxable when the bonds mature. This confused some readers, who mistakenly assumed a bond reaches maturity when its value equals its face amount. An E bond's maturity date is 20 years after it is issued; EE bonds mature 30 years after their issue date.

Send questions to Family Finance, Business Desk, Newsday, 235 Pinelawn Rd., Melville, NY 11747-4250, or e-mail to Bfamfin@aol.com. Include your age, income and a list of major assets. Letters and e-mails can't be answered personally.