There’s a tradition in this country for parents and grandparents to buy treasury savings bonds for their children or grandchildren as a savings vehicle for college expenses. Before I Bonds came along, it was done primarily using series EE Bonds and primarily in paper form. You can still use I Bonds you buy in the online TreasuryDirect account for college expenses for your children or grandchildren.
Some taxpayers naturally assume the interest will be tax-free when they cash out I Bonds for college expenses. The redemptions can be tax-free but it’s not that easy to qualify. Many people intending to use I Bonds for college expenses end up not getting the tax exemption.
Not In Child’s Name
To qualify for the possible tax-free interest, the I Bonds must be in the name of a person age 24 or over at the time of purchase. This means if you put the I Bonds in a child’s name, they won’t qualify for the tax-free treatment (unless the child is already 24 when you buy the bonds for their graduate school or professional school expenses). The child can be a beneficiary on the bonds but not an owner.
On the other hand, if a child already owns the bond and the child has no other income, the child may owe zero tax anyway when the interest from cashing out the bond is less than the standard deduction.
Your modified adjusted gross income also must be under a set limit in the year you cash out the I Bonds for college expenses to qualify for the tax-free treatment. The income limit is adjusted for inflation each year. These are the limits in 2023 depending on your tax filing status:
|Single, Head of Household
|Married Filing Jointly
I track these limits for future years in Tax Brackets, Standard Deduction, 0% Capital Gains, etc.
It doesn’t matter what your income is when you purchase the bonds. To qualify for the tax exemption on the interest, your income has to be below the threshold in effect in the year you cash out. You won’t qualify for the tax exemption if your income will always be higher than the income limits.
Qualified Higher Education Expenses
The college expenses are limited to those for yourself, your spouse, or a dependent on your tax return. This means typically a grandparent or other relatives won’t qualify for the tax-free treatment when they cash out I Bonds to pay for college expenses for a grandchild or a niece or a nephew because the student isn’t a dependent on their tax return.
Only tuition and fees qualify. Room and board don’t qualify. The expenses also can’t be already covered by scholarships or another tax benefit such as 529 plan withdrawals, the American Opportunity tax credit, or the Lifetime Learning tax credit.
If you cash out more than the qualified education expenses, the interest is prorated by the qualified expenses relative to your total cashout. You can’t just assign 100% of the interest to the qualified expenses. For example, if you cash out $20,000 consisting of $15,000 in principal and $5,000 in interest but your qualified higher education expenses in the year are only $12,000, which is 60% of your cashed-out amount, then only 60% of the $5,000 interest is exempt from taxes.
Transfer to 529 Plan
If your income in the year when you expect to pay for college expenses won’t be under the income limit but you have a lower income in a year before that time, you can take advantage of the lower income by cashing out I Bonds and transferring the money to a 529 college savings plan or a Coverdell Education Savings Account.
The amount transferred to a 529 plan or Coverdell ESA for the benefit of yourself, your spouse, or a tax dependent also counts as qualified higher education expenses. When your lower income is below the income limit in effect for that year, you won’t pay tax on the interest.
Many 529 Plans have a separate line item on the contribution form (or a separate form) to indicate that the amount you’re contributing comes from savings bonds. For example, the Nevada 529 plan managed by Vanguard has a separate source of funds on the Additional Purchase Form to break out the principal and the interest from cashing out savings bonds. Utah’s my529 Plan uses this Liquidated Funds Transfer form and the required attachment to accept proceeds from savings bonds. If you use a different 529 plan, ask customer service what paperwork they need.
The amount transferred to a 529 plan for the benefit of a dependent still counts as a gift to the dependent for gift tax purposes in the same way as a cash contribution to the 529 plan.
Change 529 Plan Beneficiary
The initial transfer to a 529 plan must be for yourself, your spouse, or a tax dependent but a 529 plan allows you to change the beneficiary afterward.
This can be a great workaround if you’re a grandparent, an uncle, or an aunt. When your income is below the income limit, you cash out I Bonds and transfer the money to a 529 plan you set up for yourself. The I Bonds interest will be tax-free in the year of the cashout and transfer. You can change the 529 plan beneficiary next year to a grandchild, a nephew, or a niece.
If you have multiple grandchildren or nephews or nieces, you can split your account into multiple accounts with each of your grandchildren, nephews, or nieces as the beneficiary.
Changing the 529 plan beneficiary from yourself counts as a gift to the new beneficiary for the purpose of gift tax and generation-skipping tax.
Pay Down Student Loans
Paying down student loans for college expenses incurred in previous years doesn’t count as qualified higher education expenses in the current year. However, if you cash out I Bonds and transfer into a 529 plan, the 529 plan allows tax-free withdrawals of up to $10,000 per beneficiary in a lifetime to repay student loans. Your income in the year of the cashout and transfer still has to be under the income limit though.
The amount allowed in this workaround is limited but it’s better than nothing.
TreasuryDirect doesn’t know whether you used the money on qualified college expenses or transferred it to a 529 plan. They will still report the interest to the IRS and issue a 1099 form.
You will still have to account for the 1099 form when you do your taxes in tax software. See Report I Bonds Interest in TurboTax, H&R Block, FreeTaxUSA. After you add the 1099 form to the tax software, it will ask you whether you used the money for qualified education expenses. The tax software will see if your income qualifies for an exemption. If you qualify for an exemption, the tax software will generate a Form 8815 in your tax return.
The tax exemption on using I Bonds for college is much harder to qualify than a 529 plan. Grandparents and other family members must use a two-step workaround through a 529 plan. You also must meet an income limit when you cash out I Bonds, whereas there’s no income limit on a 529 plan. The interest on I Bonds will be tax-free only if you’re confident your income will be under the limit at some point. If your goal is to use the money for college expenses, it’s much easier to put the money in a 529 plan to begin with.
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