Tuition Is Too Damn High, But Savings Bonds Can Help Pay for College

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As college tuition becomes more and more expensive, parents are continuously looking for the best ways to help their children pay for school. Enter savings bonds. If you meet certain conditions, the interest used on bonds may be tax free, potentially saving you a bundle. Here’s what to keep in mind if you decide to use savings bonds to help pay for your child’s schooling.

Who qualifies

Kiplinger writes that you can use I Bonds and EE bonds, which were issued after 1989, to pay for college tuition. This allows you to avoid paying taxes on the interest you have earned. But there are several qualifications you need to meet in order to avoid taxes, so make sure you meet these conditions.

  • The bond owner must have been at least 24 years old when the bond was issued. In addition, the owner must be using the money to pay qualified education expenses, meaning tuition and required fees. Note: This doesn’t include expenses for room and board or books. The owner must also either be using it for his or her own education, a spouse’s, or a dependent’s. This typically means that a parent must be the bond owner — a child can be a beneficiary but not the co-owner if you’re hoping to qualify for the tax-free benefit.
  • The other thing to keep in mind is your modified adjusted gross income, which in this context is the taxpayer’s adjusted gross income with a few exclusions and deductions added back in. For 2014, your modified adjusted gross income must be less than $113,950 for joint returns and $76,000 for single or head of household returns. The exclusion is completely phased out if your MAGI is $143,950 or more for joint returns or $91,000 for other returns. Simply put, if you make too much, you won’t be eligible for the tax break.

MarketWatch writes that if a parent makes too much but the bonds were actually intended to be given to the child as a gift and is in his or her name, the child should actually be able to cash them and report the income as his or her own, at a rate that’s most likely significantly lower than the parents.

There’s another thing to be aware of here, though. Your child could then be subject to “kiddie tax,” meaning if he or she younger than 24 and receives at least half of his or her financial support from parents, investment income of more than $1,900 would be taxed at the parents’ marginal rate, rather than the child’s lower rate. You should be able to avoid this by redeeming the bonds gradually each year so that you don’t hit the $1,900.

Filing and paperwork requirements

In order to claim the interest exclusion on savings bonds used for school costs, you must report everything in the proper manner to the IRS; this isn’t optional, so be diligent. The break is not available to taxpayers who use Form 1040EZ, reports Bankrate. Instead, you must file Form 1040A or Form 1040 and, if married, file a joint return.

If you’re a 1040A filer, you also need to complete Schedule 1, while 1040 taxpayers must file Schedule B. You’ll also have to fill out Form 8815 and attach it to your return.

Make sure you’re saving documentation that proves you paid qualified educational expenses in the year you claimed tax-free bond interest. To do this, save bills, receipts, canceled checks, and anything else that proves you paid those educational expenses during the same year you claimed the tax-free bond interest. You’ll be happy you did if the IRS ever comes calling.

The IRS also recommends you keep a written record of each bond you cash, making sure you have the serial number, issue date, face value, and total redemption proceeds (principal and interest) of each. There’s a form designed specifically for this: Form 8818. You don’t have to file 8818 with your tax return, but it’s an easy way to track the data that the IRS may someday ask for.

Disadvantages

One of the biggest disadvantages of relying on savings bonds is their lower rate of return, writes About.com. If you compare savings bonds with stock market investments, a successful stock market venture can easily outperform a U.S. savings bond.

You also need to be fully aware of all of the rules that come along with your bonds. The exemption from paying taxes on college expenses is more limited than some of the other college savings accounts. As stated previously, the only way Series EE and I bonds are exempt from taxation is when they’re used for tuition.

The escape plan

If you purchase savings bonds for your children but start to see your income rising, try to estimate your future salary, particularly what it’ll look like when your child is going off to school. If your income is rising and you realize you may be earning too much to qualify for the tax-free use of I Bonds by the time your kid hits college, you officially have an out.

Forbes reports that you can redeem your I Bonds tax-free while you still qualify, and roll the entire proceeds into a 529 state college savings plan, considered to be a “qualifying educational expense.” Whenever money is withdrawn from the 529, the earnings are all tax free as long as you put them toward college expenses.

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