Tax exclusion for savings bonds simplified
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Dear Dr. Don,
I was reading about income tax exclusions for education involving the use of savings bonds. Now I feel like I’m more confused than before! I thought that my daughter could cash in savings bonds at any time to help pay for college tuition and books and avoid being penalized for any interest accrued. Am I wrong about that?
Most of her bonds have a final maturity in 2021 and beyond. She’ll be finished with her education long before that. Would she be required to claim this as income on her income tax returns? We are trying to keep from getting too many school loans that she would have to pay off.
— Cindy College
This is more complicated than it might appear, but I think there is a path toward success as you might envision it. I’m glad you asked!
If taking advantage of the education tax exclusion for savings bonds purchased in your own name, you must be at least 24 years old to buy bonds. Translated: A traditional student may not use the tax break with savings bonds purchased in their own name.
However, this might work
For traditional students, this means savings bonds must be registered in a parent’s name, not the child’s, to take advantage of the education tax exclusion. The child can’t be a co-owner but can be a named beneficiary on the savings bond. In addition, parents must qualify for the exclusion based on their income level.
It doesn’t matter when the bonds mature since you can redeem the bonds any time after the 1st year. There is an interest penalty for early redemption of bonds redeemed within 5 years of purchase.
Only certain expenses qualify
Keep in mind that the bond proceeds must be spent on qualified education expenses during the year that the bond is redeemed to take advantage of the education tax exclusion. Such qualified expenses do not include books or room and board. In general, only tuition and fees are considered qualified expenses.
If the bonds are in your daughter’s name, then she’ll owe income tax on the interest earnings. It’s not a penalty; it’s a tax.
Most bondholders defer paying income taxes until the bond is redeemed or matured, but they can also choose to pay the tax annually instead. Switching from deferral to paying on an annual basis is always an option.
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