Savings Bonds and College

by Gary Foreman

Dear Dollar Stretcher,
Our 17 year old will begin college in the fall. We have quite a few savings bonds for her and we'd like to cash in the mature ones. What do we need to know about any tax that will be due on them? Will she need to claim the money from them on her tax forms next year? She works part time and will likely continue in the summers. Is this considered "income" for her?
Thanks so much!

Trish is at an interesting time for parents. The point where pride in our kid's accomplishments runs smack into the pain of paying for college! And it does take a lot of money to get that college degree. According to when you include tuition, books, room & board, transportation and personal expenses, the average student at a public college or university will spend $10,458 per year.

But, that shouldn't deter Trish or her daughter. The average college graduate earns 81% more than someone with a high school diploma. And, most college students receive financial aid. Of full-time students, sixty percent at public colleges and universities receive some form of aid. hopefully Trish's family has explored those options.

OK, let's take a look at that stash of savings bonds. There may be a happy surprise for Trish. We'll need to review savings bonds and how they work. About ten years ago savings bonds got a facelift and also got more complicated.

For years the most popular bond was the Series E/EE. You purchased a bond at a discount to the face amount of the bond. Gradually it gained value until the maturity date when you redeemed it at the full face amount. And that's when you paid federal income taxes on the interest earnings. Your principal and interest was guaranteed by the U.S. Government. You can still buy Series E/EE bonds.

Another group of savings bonds, Series H/HH, distribute income to you every six months. The lowest denomination is $500. The interest rate is set when you buy the bonds and is adjusted on the 10th anniversary of the issue date. They've paid 4% since 1993.

If you have E/EE bonds and want to begin collecting income without redeeming the bonds you can exchange them for HH bonds. That allows you to continue to defer much of the income tax until you cash in the HH bonds or they reach their maturity date.

Finally, there's a series of savings bonds that are adjustable for inflation. Series I bonds accrue interest. They're purchased at face value. Holders receive interest in two parts. You get a fixed return that is set at the time the bond is purchased. Then there's a variable return that's adjusted twice a year for inflation. I bonds come in denominations as small as $50.

Taxes on Series I bonds are delayed until you redeem the bond or begin to collect your interest. The income is exempt from state and local income taxes. For current rate information on all savings bonds call 1-800-487-2663.

Now, to answer Trish's first question. Yes, the income from the bonds is taxable under most circumstances and must be declared by the bond owner.

One thing could help Trish's family. Series EE bonds issued after January, 1990 and all series I bonds are eligible for the "Education Bond Program". If you spend money for tuition, room, board and other qualifying educational expenses the program allows for interest to be partially or completely excluded from Federal income tax.

The program does have some family income limits that could reduce or eliminate this benefit. It also requires that the bonds be owned by the parent(s) unless the student is 24 years old or older. But, even if Trish's daughter owns the bonds, under certain circumstances they can be re-registered.

Trish's family will also want to take advantage of the standard deduction available to her daughter. She can earn up to $4,400 in wages or $700 in unearned income (i.e. interest from savings bonds) per year without having to pay taxes. That amount of income will still allow her parents to claim her as a dependent on their tax return. She will need to file a tax return to get a refund on taxes that were withheld.

Congrats to Trish's daughter on her high school graduation. Hopefully college will be a wonderful experience for her.

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, and Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.

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