You recently asked about investing in U.S. savings bonds to take advantage of tax-free interest where the bonds are used to pay for college tuition.
Here’s how the rules work: The bond must be issued to an individual at least 24 years old. That is, the bond will be issued to you, rather than to your child who will be attending college. It can be owned jointly by you and your spouse, but not jointly with anyone else (such as your child).
Only Series EE and Series I U.S. savings bonds qualify—these are the bonds bought at a discount that accrue earnings over time.
For the interest to be excludable, the proceeds from the bond must be used for “qualified higher education costs” for any individual who is your dependent (or for you or your spouse). Costs which qualify are for tuition or fees at a college or graduate school. (Nursing schools and some vocational schools may also qualify.) Room and board costs do not qualify.
If the bond proceeds exceed the qualified expenses, only a proportionate share of the interest will be excluded. For example, say a qualifying bond is redeemed and $8,000 in proceeds are received: $2,000 of interest and $6,000 of principal. Of the $8,000 in proceeds, $7,000 (that is, 7/8) are spent on qualified higher education costs. In this situation, 7/8 of the interest, or $1,750, is the excludable amount. The rest of the interest ($250) is taxable.
Phase-out of benefits. The bad news in many cases is that the benefit of the interest exclusion is “phased out,” i.e., taken away, if your adjusted gross income (AGI) in the year the bonds are redeemed is above a set amount. To compute your AGI for this purpose, you must include the interest. For married couples filing jointly, if the 2010 AGI is more than $105,100 ($106,650 for 2011) and less than $135,100 ($136,650 for 2011), a portion of the exclusion benefit is lost; and if that AGI is $135,100 ($136,650 for 2011) or more, the exclusion is not available and all of the interest is taxable. The amounts for future years change annually to reflect inflation.
For unmarried taxpayers, the phase-out of benefits starts at $70,100 of AGI in 2010 ($71,100 in 2011) and increases until there are no benefits for AGI of $85,100 ($86,100 in 2011).
Please let me know if you have any additional questions. I’d be happy to help you plan towards meeting future college costs.
Very truly yours,
O’Baker & Company