Funding 529 with Bonds Hurts Financial Aid

I am a 70-year-old grandmother who still works. I also collect my former husband’s Social Security and pension. I would like to redeem some post-1989 Series EE savings bonds that I inherited to set up 529 college plans for my two grandchildren.

Can you tell me if the interest on these, which will be considerable — approximately $450 on each $50 savings bond — is taxable interest?
— Mary Ann Mobilize

Dear Mary Ann,
It’s not as straightforward as you would hope, but you may be able to do this in a roundabout way by using the proceeds to fund Section 529 college savings plan(s) in your name as owner and beneficiary and subsequently change the named beneficiaries to your grandchildren, as long as you qualify for the educational tax exclusion. More on that to follow.

I asked Mark Kantrowitz, senior vice president and publisher of Edvisors.com, to help me with this reply, but both he and I recommend that you get professional tax advice before taking these steps. Here are Mr. Kantrowitz’s thoughts about your goal.

“For the interest on a Series EE U.S. savings bond issued in 1990 or a later year and the interest on a Series I bond to be tax-free under the IRS’ Education Savings Bond Program, the bonds must be owned by the taxpayer (not co-owned by the dependent) and the purchaser must have been age 24 or older when the bond was issued. The bonds must either be redeemed to pay qualified higher education expenses of the taxpayer, the taxpayer’s spouse or the taxpayer’s dependents, or rolled into a qualified tuition plan.

There are also income phaseouts that apply to the taxpayer for tax-free treatment (2014 tax year):

  • $76,000 to $91,000 (single)
  • $113,950 to $143,950 (joint)

If the bonds are rolled over into a qualified tuition plan, the qualified tuition plan must specify the taxpayer, taxpayer’s spouse or the taxpayer’s dependent as a beneficiary, per 26 USC 135(c)(2)(C).

Nothing stops the owner of the qualified tuition plan account from subsequently changing the beneficiary to a grandchild, since 529 savings plans allow the beneficiary to be changed to a child or descendant of a child of the current beneficiary. The grandparent should confirm with a CPA or other tax professional that such a change in the beneficiary will not result in generation-skipping taxes.

However, note that if a grandparent owns a 529 savings plan or other qualified tuition plan, it can have a negative impact on eligibility for need-based financial aid. If a 529 savings plan is owned by the student or a dependent student’s custodial parent, it is reported as an asset on the Free Application for Federal Student Aid (FAFSA), but distributions from the 529 plan are ignored.

If the 529 plan is owned by anybody else, it is not reported as an asset on the FAFSA, but distributions are reported as untaxed income to the beneficiary. Untaxed income to the beneficiary can reduce aid eligibility by as much as half of the distribution amount, a much greater impact than reporting the 529 plan as an asset on the FAFSA.”

Along with consulting with a tax professional, you should consult with the parents on whether they want you to fund these accounts for their children. Finally, although it’s seldom the case, the estate of the decedent may have paid the taxes due on the savings bond interest up to the point when you inherited the bonds. If that was the case, part of the interest income from the savings bonds would already have been taxed.

It’s not as straightforward as you had hoped, but if you qualify for the education tax exclusion and the parents agree to it, you can put these bonds to work for your grandchildren’s educations without paying the taxman first.