Using Savings Bonds as Tax-Free College Savings? 7 Things to Know First

Here’s a recent question regarding EE US Savings Bonds, which are often touted as a great way to use tax-free interest to help fund a child’s college education. If you’ve ever bought any for that purpose, considered it or know someone who has, it’s interesting information. Here’s the question:

I would like a response on this. Buying EE savings bonds is often suggested as a way to save for college. It is often stated that if the bonds are redeemed and used for college that the interest is not taxed.

Personally from my experience the Government and banks that sell them, have not been giving us the whole story. First and foremost, to be non-taxable, the purchaser must be either the person them self or the parent, not a grandparent, uncle/aunt, good friend, etc. My mother-in-law bought my sons EE bonds and they are not non-taxable. I think many Grandparents have fallen for this little government scam. Second, they have to be used for tuition, not room, books, or board. The most common type of scholarship are applied to tuition, so if you get scholarships that pay for most of your tuition you are hosed.

If you if have information regarding redemption of EE Bonds for college cost where the interest is non taxable I should would like to know how it is done. I think be best way would be for the grandparents to just give cash, and have the parents or child buy the bonds in their name, but I think its too late for us now. Why banks let grandmothers buy the bonds is beyond me. Do I have any recourse?

-Paul

Here’s your answer Paul: First, everything you’re saying is true. In order to be redeemed tax-free for use in education, the bonds must be purchased in the name of a parent, not a grandparent, in-law, friend, etc. There are other restrictions worth noting as well, including income restrictions. You can read about them at the Treasury’s page explaining EE Bonds for education. But here are the basics:

Seven Rules to Qualify for Tax-Free Interest of Savings Bonds Used to Meet Education Expenses

1. The education expenses must be incurred in the same tax year you redeem the bonds.
2. You’ve got to be at least 24 years old when you buy the bonds.
3. When using bonds for your child’s education, the bonds must be registered in your name and/or your spouse’s name. (The child can be listed as a beneficiary, but not owner.)
4. If you’re buying bonds for your own education, they’ve got to be registered in your name.
5. If you’re married, you’ve got to file a joint return to get the exclusion.
6. If you make too much money, you won’t get the exclusion. IRS Form 8815 will help you figure out how much is too much, but for tax year 2009, the exclusion started phasing out at about $70,000 of adjusted gross income for single taxpayers and $85,000 for joint filers.
7. Your post-secondary institution has to meet the standards for federal assistance, such as guaranteed student loan programs.

Qualified Expenses

• Tuition and fees (such as lab fees and other required course expenses).
• Expenses that benefit you, your spouse, or dependent for whom you claim the exemption.
• Expenses paid for any course required as part of a degree or certificate-granting program.
• Expenses paid for sports, games, or hobbies qualify only if part of a degree or certificate program.
• The cost of books or room and board are NOT qualified expenses. The amount of qualified expenses is reduced by the amount of any scholarships, fellowships, employer-provided educational assistance, and other forms of tuition reduction.

So in summary, Paul, you’re right: If you want to get tax benefits by buying savings bonds for education, you’ve got to jump through a lot of hoops. And if you’re not a parent, the only way around the ownership restriction would appear to be giving cash to the parents and having them purchase the bonds in their name, or just purchasing the bonds in the parent’s name and giving them the bonds.

As for recourse, it’s easy to imagine an uninformed bank employee selling bonds to a grandmother, or other interested party, without fully understanding the rules or making them clear. In this day and age of the “financial supermarket” when so many banks are attempting to be all things to all people, mistakes like this are probably common. If it were me, I’d talk to the bank manager, explain the situation, then ask what can be done to make the situation right. For example, perhaps the bank can aide in the process of having the bonds transferred into your name, so when the time comes the interest can be used as intended: as tax-free assistance for the qualified education expenses of your sons.

As for your comment “if you get scholarships that pay for most of your tuition you are hosed”, let’s look at this from a different angle. If your sons have full scholarships for college, you may be “hosed” in terms of achieving tax-exemption for the interest on your EE savings bonds, but you’re still a very lucky guy. Cash in the bonds, pay Uncle Sam (the interest will be state tax-exempt) and use the money to fund a big party to celebrate being a great parent with brilliant sons and a generous mother-in-law! Believe me, worse things can happen.