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Tax-wise cashing of savings bonds


Dear Tax Talk,
My ex-wife and I invested $20,000 in EE savings bonds back in 1986 from my late father's estate. We're looking to cash them in and set up a 529 or similar account for educational purposes. The bonds are in the children's Social Security numbers. Please advise us on the best way to divest without paying too much in taxes. Thank you. -- Chet

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Dear Chet,
In certain circumstances, interest on Series EE savings bonds can be excluded from income if used to pay for educational expenses, including contributing to a Section 529 plan or a Coverdell educational savings account. However, it only applies to EE bonds issued after 1989 and owned by you and not the children. You also have to fall below certain adjusted gross income limits.

If you cash in the bonds today, the kids would end up paying the tax due on the earned interest without any tax break for educational expenses since presumably they are your dependents or those of your ex. Doing a rough calculation on the U.S. Treasury's savings bond site, the children would be paying tax on approximately $40,000 in interest. Assuming you have two kids and they are over age 13, they'd each be taxed on $20,000 in interest and would pay about $2,500 in federal tax. States exempt savings bond interest.

You don't say if the bonds were originally bought in 1986 under the children's names or if you later transferred them into their names. If the bonds were bought in their names, then the kids have to be over 18 years of age. It wouldn't give you much advantage to establish a Section 529 plan when the kids are ready for college or in college already. Since the kids would be in need of the funds, your investment approach would have to be extremely conservative, and that would mean there would be little or no taxable income that would be sheltered by the 529 plan.

Your best bet may be for the kids to cash in the bonds annually over their four years in college. Doing this would bring their tax down to about $425 annually based on current tax rates.

-- Posted: Nov. 19, 2004




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