U.S. Savings Bonds: A tax education

Areader recently wrote us about a tax dilemma.

“We bought U.S. Savings Bonds for my daughter when she was born and she also received Series EE Bonds as gifts. Now that she is entering her freshman year at college, we want to use the bonds to pay for tuition. Should she cash in all the bonds this year? And if she does, is all the interest tax exempt if the money is used to pay for college? Please help us out.” Anonymous

Dear Anonymous: We will be glad to help. The tax exemption you refer to is extremely limited and you probably don’t qualify. But it still might be a good idea to redeem some or all of the bonds.

For starters, interest on Series EE Bonds is taxable when the bonds are cashed in or mature, whichever comes first. Alternatively, you can elect to pay tax on the accrued interest on an annual accrual basis, but you must do this for all your bonds.

The interest on U.S. Savings Bonds may be exempt if the funds are used to pay for qualified higher education expenses, but this exclusion only applies if:

  • The bond is a Series EE or I Bond issued after 1989
  • The owner was at least 24 years old when the bond was bought
  • A child is not listed as an owner or co-owner of the bond.

Thus, bonds purchased by a parent and issued in the name of the child do not qualify. This could knock you right out of the box. In addition, this special tax exclusion phases out at moderate income levels. For 2017, the phaseout occurs between $78,150 and $93,150 of modified adjusted gross income (MAGI) for single filers and $116,300 and $146,300 for joint filers.

Nevertheless, if the bonds were issued in your daughter’s name, it still may make sense to have her redeem the bonds while she is in a low tax bracket. The funds can be used for her tuition even if the tax exclusion is unavailable.

Tip: Reduce the tax bite by spreading out redemptions over several years.