Jim has Series I Savings Bonds in his name that have accrued a large sum of interest, but he is struggling to determine how he should fund his children’s college education. He knows that I-bond interest can be excluded from taxes when used for qualified tuition and fees, but his children won’t be going to college for at least another 5-10 years. Jim was surprised to hear that he could roll the I-bonds into their 529 accounts tax-free, expanding the list of qualifying expenses he can use the money on and how those funds can be invested in the mean-time.
Key Points:
- You may be able to exclude the interest on Series EE issued in 1990 or later and I bonds if used for qualifying higher education expenses, or if rolled into a 529 account.
- There are income limits on who can use this strategy. Single filers with an AGI in 2023 of less than $106,850 or married filing joint filers with an AGI of $167,800 in 2023. (Check pg. 3 of Form 8815 to annual updates)
- Redemption and subsequent 529 contributions must be made within a 60 day period in the same calendar year.
- This can be a good strategy when your savings bond returns are no longer adequate, you are looking for more spending flexibility, or even if you want to help fund your grandchild’s college education.
So What are U.S. Savings Bonds?
For education planning purposes, the most common U.S. savings bonds are Series EE and Series I bonds, which you can buy directly from the Treasury. Series EE bonds earn a 20-year fixed interest rate, which is paid monthly and accrue on the bond principal. These bonds are guaranteed by the government to double over the 20 year period. Series I bonds earn a fixed interest rate, plus an inflation adjusted interest rate depending on inflation data. Both bonds restate their interest rates semi-annually, in May and November, and interest is generally not taxed until you redeem the bond and receive the interest. The interest on these bonds is not subject to state and local income taxes, and the interest may be excluded from federal income taxes if used for qualifying education expenses.
Excluding interest income from federal taxes
There are some rules surrounding who can exclude the savings bond interest income from their gross income, and how much of that interest can actually be excluded. First, the bond holder must be at least age 24 prior to purchasing the bond, and bonds used for a child’s education must be registered in the parent’s name.
Next, the bond must be redeemed and the interest used for qualifying education expenses within the tax year. Qualifying education expenses are off-set by any tax-free educational assistance that is received, such as scholarships or 529 plan distributions, and the expenses must be paid for the taxpayer, their spouse, or their dependent(s).
Any interest received from the bond in excess of the adjusted qualified higher education expenses will be included in the taxpayers gross income. For savings bonds, qualified education expenses are limited to tuition and fees of qualifying higher education programs, as well as contributions to Qualified Tuition Plans (QTP).
There is also a phase-out of the interest exclusion based on your Modified Adjusted Gross Income (MAGI). For 2022, the phase-out is $85,800 – $100,800 for single filers and $128,650 – $158,650 for those married filing jointly. You are ineligible for the exclusion if you are married filing separately. Additionally, the interest on the savings bond counts as income for purposes of the phase-out in the year it is redeemed, so you may need to adjust your redemption strategy to account for this.
*Talk to your CPA if you want to execute on this strategy and before making any changes. This article is general education and not tax advice.
How to Roll an I-Bond to a 529 Tax-Free
One of the most important factors that makes this strategy viable is the inclusion of Qualified Tuition Plans, like a 529 or Coverdell education savings account, in qualified education expenses for purposes of the exclusion. This allows you to contribute your principal and interest income to the QTP and claim the exemption as long as you meet the other eligibility criteria described above. So how exactly do you roll an I-bond to a 529 account?
The savings bond cannot be directly rolled into the 529 plan, so you must redeem the bond and deposit the proceeds into the 529 account within 60 days of redemption. You must contribute the entire proceeds to the 529 plan, otherwise a portion of the interest would be taxable. This means if you bought the bond for $10,000 and redeemed it for $13,000, you must contribute the entire $13,000 to the Qualified Tuition Plan to exclude the $3,000 of interest income.
To actually exclude the interest on your tax return, you will need to file a Form 8815, where you can put who incurred the expense (you, your spouse, or a dependent), the eligible educational institution (in this case a Qualified Tuition Plan), and the amount of your qualified higher education expenses and savings bond proceeds.
This is general information only. This is not tax advice. Please consult with your tax advisor before adopting this strategy.
Can I do this for my grandchild?
In short, yes, it is possible to roll an I-bond to a 529 account to fund your grandchildren’s college education, but there are some details you need to get right for this to work. First, the savings bond must be held in the taxpayer’s name, in this case the grandparent.
Additionally, because you can only exclude the interest when used for yourself, your spouse, or a dependent, the grandparent must be the named beneficiary of the 529 account when the contribution is made, but they do not need to be the account owner.
Once the proceeds are moved to the 529 account within 60 days of redemption, the 529 account owner can change the beneficiary to the grandchild.
Why would you roll an I-bond to a 529 account?
One of the biggest advantages of this strategy is that Qualified Tuition Plans have a much wider range of qualified education expenses, which includes room and board, books, computer equipment, and other items that you may purchase with a child in college. In contrast, you would generally only be able to exclude savings bond interest if you use the entire proceeds toward tuition and fees, and you would not be able to exclude the interest used for other expenses.
Additionally, 529 plans generally have a wider range of investment options, from stock and bond portfolios to prepaid tuition plans that track the cost of certain colleges. This may be attractive if your EE bond’s interest rate is no longer competitive or your I bond’s interest rate is suddenly much lower.
You may also consider this strategy if you expect to be phased out of the interest exclusion within the next few years but had planned to use those bonds for education expenses. In this case, you may decide to roll the I-bonds to a 529 when you know you can exclude the interest from your federal taxes, rather than paying taxes on the potentially higher accrued interest in the future.
Are there any disadvantages?
There are certainly some factors that may stop you from implementing this strategy. To start, you may be getting an above average return on your savings bonds. For example, I-bonds are currently offering around a 3.38% APY interest rate through November 2023 (if you purchase an I-bond between May 2023 and Nov. 2023 you will also earn a fixed rate of 0.9%). This makes I-bonds interesting but not as interesting as they were at the end of 2021 and into 2022.
Another obvious disadvantage of this strategy is that it is still subject to the same MAGI phase outs that are applicable if you use the proceeds directly for tuition and fees. This excludes many individuals from participating in this strategy who make too much for the interest exclusion. These individuals may decide to simply hold their savings bonds and make regular 529 contributions instead.
The contents above should not be construed as financial or tax advice. Please consult your tax advisor before making any changes.
