Q. We read your article on government bonds, of which we have been long-term purchasers and have quite a large Treasury-Direct account. Your comments about using them for college conditionally tax free is most interesting since our son began college this fall. What are the tax free requirements?
If we qualify for the tax exemption, do you recommend using cash we have on hand or redeeming bonds for the tax exemption?
The bonds were purchased between 1992 and 2003. Most of the EE bonds are earning about 4 percent, and some I bonds are earning as high as 7.67 percent. The cash in CDs and money markets are earning about 2 percent, and we have enough to cover the tuition expense for four years of college. We also have approximately $22,000 in a Coverdell IRA. With CD rates so low, we are tempted to hold onto the bonds and pass up the tax savings if we qualify. But, if we don't use the bonds for education, we may never qualify for the tax exemption. Our taxable income will be low for the next two years, however; in 2013, my husband will be taking required minimum distributions from his IRA and 401(k) accounts, and we may not qualify for the full tax exemption if income limits are part of the formula.
The exclusion of interest when redeeming a bond for education expenses has several requirements, most of which it sounds like you meet. You must have been at least 24 years old before the bond's issue date, the issue date must be after Dec. 31, 1989, the expense must be for tuition and fees at a qualified educational institution, and your modified adjusted gross income must not exceed the IRS income limits adjusted for inflation.
Your MAGI is your AGI (which is found on line 38 of tax form 1040) with certain exclusions added back to that figure. Use the worksheet for line 9 of form 8815 to figure your MAGI for the savings bond tax exclusion. The 2011 income limitations are not yet on the IRS website, but they shouldn't be significantly different from the following 2010 limits: for single taxpayers, the tax exclusion begins to be reduced with a $70,100 MAGI and is eliminated for MAGI of $85,100 and above; for married-filing-jointly taxpayers, the exclusion begins to be reduced with a $105,100MAGI and is eliminated for $135,100 and above.
Even if you qualify for the education tax exclusion on your bonds, I suggest you use your cash and the Coverdell education saving account, and keep your bonds since the interest rate is so much higher than any available safe investment. Use the Coverdell first. The funds must be used for education-related expenses, and if not, must be distributed by the time your son is 30 with taxes and penalties owed on any appreciation in the account.
Don't forget about the new college tuition tax credit Congress enacted for 2010-2012. This credit will revert to the less advantageous Hope Tax Credit if not extended or made permanent. A Coverdell or ESA distribution will not impact your ability to qualify for this tax credit as long as different expenses are used for both benefits. This tax credit is worth up to $2,500. Unfortunately, it also has income limitations. For single taxpayers, the tax credit begins to be reduced with an $80,000 MAGI and is eliminated for $90,000 and above; for married-filing-jointly taxpayers, the credit exclusion begins to be reduced with a $160,000 MAGI and is eliminated for MAGIs of $180,000 and above.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question.
