I read your article on rolling savings bonds into a 529 plan but I
am still not sure of one thing. If we are over the income threshold
for tax-free redemption, can we roll the bonds into the 529 and avoid
paying taxes on the bonds? Then when we take deductions from the 529
to pay for qualified expenses do we have to pay taxes at that point?
— Maria A.
To avoid a tax liability when redeeming US savings bonds, the bond
owner's income must fall under the income phaseouts during the tax
year when the bonds are redeemed. This requirement applies regardless
of whether the proceeds are used to pay for qualified higher education
expenses or are rolled into a 529 college savings plan, prepaid
tuition plan or Coverdell Education Savings Account.
If the bond owner expects to have income above the income phaseouts
when the child enrolls in college, but currently has income below the
phaseouts, the bond owner should consider redeeming the savings bonds
now to roll them into a 529 college savings plan. The current
redemption will be tax-free because the bond owner's income is below
the income phaseouts and the rollover into a 529 college savings plan
qualifies for tax-free treatment. Since there are no income phaseouts
on tax-free distributions from 529 college savings plans, the future
distributions to pay for qualified higher education expenses will also
be tax-free. Thus rolling US Savings Bonds into a 529 college savings
plan can be an effective method of bypassing the income phaseouts on
tax-free redemptions of US savings bonds.
But if the bond owner's income is above the income phaseouts now and
the bond owner expects his or her income to continue to be above the
phaseouts when the child enrolls in college, there's no way to avoid
paying income taxes on the savings bonds.
The income phaseouts in 2011 were between $71,100 and $86,100 for single
filers and beween $106,650 and $136,650 for married taxpayers who file
jointly. Married taxpayers who file separate returns are not eligible
for tax-free redemption of US savings bonds.
Eligible US savings bonds include Series EE bonds issued after 1989
and Series I bonds.
To claim the interest exclusion, taxpayers should file IRS Form 8815
with their federal income tax returns.