Devoted to Estate and Tax Planning
4th Quarter, 1995 -- Vol. 1, No. 1 © 1995 De Maio & De Maio
In This Issue:Feature Article
Using Savings Bonds to Pay for College: A Parent's GuideRecent Developments
Estate Tax Changes Proposed New Jersey Enacts Standby Guardian Law Independent Contractor Rules May Change Family Dispute Centers on Ownership of Life Insurance Well Said
Taxing quotes
Feature article:
Using Savings Bonds to Pay for College: A Parent's Guide
By Andrew J. De Maio, Esq.
Congratulations. You've started saving for those college tuition bills that will be arriving all too soon. Among the investments earmarked for college, you probably have some U.S. savings bonds. Some of the bonds may be in your name. Others, received as gifts, probably list the child as owner or as co-owner. You probably haven't given much thought to the form of ownership. But this seemingly mundane detail can make a great deal of difference in the amount of income tax payable on the interest earned by the bonds.
In 1988, Congress passed an income tax break for parents using EE savings bonds to save for college. When these bonds are redeemed by parents and the proceeds used to pay educational expenses, the accrued interest on the bonds is tax-free if certain conditions are met. This exclusion can provide significant income tax savings for those who qualify. But it is not for everyone. Sometimes, trying to qualify for the exclusion can actually cause you to pay more income tax.
This article will review the conditions that must be met to be eligible for the educational savings bond exclusion. It will then describe three tax-planning strategies for savings bonds, and help you choose among them. Although it is geared toward parents with young children, it will be useful to anyone who has ever given a savings bond as a gift.
REQUIREMENTS FOR THE EXCLUSION
The educational savings bond exclusion is contained in section 135 of the Internal Revenue Code. To qualify to receive savings bond interest tax-free, four basic conditions must be met.
1. The age requirement.
The savings bond must be originally issued in the name of a person or persons age 24 or older at the time of purchase. Thus, bonds purchased in the name of the child, or the child jointly with a parent, cannot qualify for the exclusion. The child may be named as beneficiary eligible to receive the bond on the death of the parent or parents.
2. The income limitation.
Parents cannot qualify for the exclusion if their "modified adjusted gross income" for the year in which the bonds are redeemed is above certain levels. To fully qualify in 1995, the income limit was $42,300 for an unmarried taxpayer and $63,450 for a couple filing jointly. (The exclusion is not available to married couples filing separately.) Parents with incomes above these levels may qualify for a partial exclusion. But no tax benefit at all is allowed to individuals with incomes over $57,300, nor for couples filing jointly whose income exceeds $93,450. These figures are indexed for inflation.
3. Payment of "qualified higher educational expenses".
To qualify, the taxpayer must pay expenses for higher education in the year in which the bonds are cashed. The expenses must be for the taxpayer, the taxpayer's spouse, or a dependent. Thus, grandparents may not take advantage of the exclusion unless the child is their dependent for tax purposes. The charges must be paid to an eligible educational institution (generally, an accredited college, university or vocational school).
It is not necessary that the bond proceeds themselves be spent for educational expenses, as long as the expenses are paid in the same year the bonds are redeemed. Thus you can pay the expenses from other available funds early in the year and redeem the bonds later. If the amount of the bond proceeds exceeds the expenses, then only part of the proceeds is tax-free.
4. Post-1989 EE Bonds only.
The exclusion is available only for qualified EE U.S. Saving Bonds issued after December 31, 1989. Bonds issued before that date are not eligible, even if registered in the parent's name. EE bonds obtained in a tax-free rollover of E bonds are not eligible.
STRATEGIES
Plan A: Qualify for the Exclusion
The first strategy is to do everything you can to qualify for the educational savings bond exclusion described above.
How it Works
Step 1. Place ownership of the bonds in name of one parent or both parents jointly.
Step 2. Leave the ownership unchanged until the child goes to college.
Step 3. Redeem bonds during a year you (the parent) pay qualified educational expenses.
Step 4. Report the exclusion on Internal Revenue Service Form 8815 and attach it to your tax return for the year.
Unfortunately, there is some risk in pursuing this strategy. Your income level many years from now, at the time of bond redemption, may deny you the exclusion. Or the law could be amended between now and then to change or eliminate this tax benefit. If you have put the bonds in your name in the hope of qualifying, the interest income on redemption will be taxed to you rather than the child. Since your marginal income tax rate will probably be higher than your child's, you will likely pay more tax than if the bond were owned by the child.
Plan B: Elect current income
A good understanding of this strategy requires some background information in two areas.
First, each taxpayer is allowed a certain amount of income before being subject to income tax. The first dollar of income received is never taxed. A child who can be claimed as a dependent on his parent's return can have up to $650 in income in 1995 without having to pay tax or file a return. The income of many young children is well below this threshold. Their income can be increased, up to the $650 threshold, without causing them to pay any tax.
Second, you have a choice of when to report income from EE savings bonds. Generally, you report the interest as income only when the bond is cashed. However, you can elect to include in income each year the accrued increase in the value of the bond. Income that you report in this way is not taxable when the bond is cashed. Making this election accelerates the reporting of income. Usually, that is not a good idea because it's best to delay income for tax purposes. But when a child's income is below the threshold for filing a return, any additional income below the threshold is tax-free. In that situation, making the election for savings bonds in the child's name can eliminate the tax on the bond interest.
How it Works
Step 1. Put bonds in the name of the child alone. This makes the interest taxable to the child. A parent or another adult may be named as beneficiary of the bonds on death of the child. Joint ownership should not be used because IRS says interest on a joint bond is taxable to the owner who purchased it, and not necessarily the one who cashes it.
Step 2. Make the election to realize income currently. This is done by filing an income tax return (Form 1040) for the child for the year in which the election is made. The return should state that the election to report E and EE savings bond interest as current income under Internal Revenue Code Section 454 is being made. The accrued interest for that year and all previous years during which the bonds have been outstanding should be listed on the return as income. In subsequent years, the child does not have to file a return unless the amount of income for that year, including bond interest accrual, exceeds the filing threshold. Keep in mind that this election applies to all E and EE savings bonds in the child's name.
Step. 3. Keep track of the accrued interest on the bonds each year. You can do this by looking up the redemption values in a publication available from the US Treasury, Bureau of the Public Debt, Savings Bonds Marketing Office, Washington, D.C. 20226. Or you can let your computer calculate the increase in value each year. Programs that perform this calculation are available from the US Treasury and from private sources. See Further Reading, at the end of this article.
Step 4. When the bonds are cashed, report as income only the interest accrued during that calendar year, even if you receive an information return showing a higher amount.
An Example:
Johnny, age 7, receives annual income of $75 from investments in his name. In addition, he owns Series EE US savings bonds with a total face value of $5,000, which he received at various times during 1994. The savings bonds increased in value by $100 in 1994 and by $250 in 1995. Under the deferred method of reporting, the savings bond interest for the entire life of the bonds will be taxed to Johnny when the bonds are redeemed. Instead, Johnny's parents file a 1995 income tax return for him, making the election to currently report savings bond interest. On that return, they must report the 1995 bond interest ($250) and the previously accrued interest ($100). Even with the $350 of savings bond income, Johnny's income for 1995 is below $650, so he pays no tax. In subsequent years Johnny's income, including interest accrued on all savings bonds, is less than the applicable filing threshold. Johnny cashes the bonds at age 19. The previously accrued interest is not taxable at that time, since it was previously reported. Johnny will never have to pay income tax on the savings bond interest.
Changing back to deferred reporting
As your child accumulates investments, his or her income may increase to the point that it exceeds the filing threshold. If that occurs, keeping the election in place is no longer desirable if it requires the current payment of tax on income that could be deferred. You can change back to the deferred method of reporting by obtaining permission from the IRS. That sounds more difficult than it is. You can obtain permission automatically by filing IRS Form 3115. The procedures are described in IRS Publication 550, Investment Income and Expenses.
Plan C: Deferred reporting
The third strategy is the simplest. It simply involves putting bonds in the child's name and delaying the reporting of interest income until the bonds are redeemed to pay for college.
How it Works
Step 1. Put the bonds in the name of the child. As explained under Plan B above, joint ownership should not be used.
Step 2. Leave the bond in the child's name until needed to pay college expenses.
Step 3. Redeem the bonds when funds are needed for educational expenses. The accrued interest is taxable to the child, at the child's tax rate. If the bonds are redeemed when the child is under age 14, the parent's tax rate may apply.
Custodial account registration
Plans B and C call for bonds to be owned in the child's name. If this form of ownership is used, and if the child has possession of the bond, he or she can redeem it without the consent or knowledge of the parent. An alternative is to have the bond issued to a custodian under the Uniform Transfers to Minors Act (UTMA). Under a UTMA custodianship, the custodian has the power to make investment decisions and to use the funds for the minor's benefit. The child has no right to outright ownership until the UTMA age of majority. In New Jersey, the age is 21 unless a lower age between 18 and 21 is specified when the account is created. Placing the bonds into a trust for the child's benefit is another option.
CHOOSING A STRATEGY
If the child's annual unearned income is comfortably below $650, Plan B (electing current income) should probably be your first choice. This option requires some paperwork and periodic reviews. But it lets you avoid tax, not just defer it. Because the tax benefit is received and claimed currently, it is not dependent on the whims of Congress nor on your future income level.
If the child's income level is above $650, take a hard look at qualifying for the educational savings bond exclusion (Plan A). This option offers the possibility of the greatest tax savings, if you can meet the requirements. But it involves uncertainty. If your income level is too high at the time the child is in college, you will lose all or part of the tax benefit. Changes in the law may also defeat this strategy. Congress could repeal the educational savings bond exclusion altogether, or replace it with other tax breaks, like expanded IRAs that permit saving for education on a tax-free or tax-deferred basis. To make the decision more difficult, once you choose this strategy by placing the bonds in your name, you can switch to a different plan only at a cost. If you change ownership of the bonds to the child's name, you incur income tax on the interest accrued to that point.
If your child's income is over $650 and you don't want to rely on the educational savings bond exclusion, consider Plan C. The bond interest will eventually be taxed, but at the child's tax rate.
To some extent, you can combine strategies. For example, some bonds can be held in the name of the parent or parents, potentially qualifying for the educational exclusion, while others are owned by the child.
FINAL THOUGHTS
It's difficult enough to save for your child's education without being burdened by unnecessary taxes. The form in which savings bonds are owned can make a big difference in the income tax bill. Choose a strategy or strategies, and review the circumstances periodically.
Once you decide on the best form of ownership, make your preference known to relatives who may be inclined to give savings bonds as gifts. If you choose Plan A, good luck convincing Uncle Harry to put the bonds in your name, and not your child's. Perhaps a copy of this newsletter will help.
FURTHER READING
Internal Revenue Code Section 135
The U.S. Treasury publishes information about savings bonds on the World Wide Web. A DOS program that calculates the current value of E and EE savings bonds may be downloaded from this site.
You can download federal tax forms, including Form 8815 and Form 3115, from the IRS at http://www.ustreas.gov/treasury/bureaus/irs/taxforms.htm
Information about financial aid on the World Wide Web
IRS Publication 550, Investment Income and Expenses, available from IRS by calling (800) 829-3676
IRS Publication 929, Tax Rules for Children and Dependents, available from IRS by calling (800) 829-3676
Recent Developments
Estate Tax Changes Proposed
Legislation currently pending in Congress may make significant changes in the federal estate tax laws. One proposal would increase the exemption available to each person from the current $600,000 to $750,000, and index it for inflation in future years. This bill would also index the annual $10,000 gift tax exclusion for inflation. An alternative proposed by Senator Dole and others in July would provide "targeted" estate tax relief to the owners of family businesses and farms. Qualifying businesses and farms worth up to $1.5 million would be completely exempt from tax. One half of the value in excess of $1.5 million would be tax-free under this measure. E-mail subscribers of Foresight will receive updates on the progress of these and other estate tax proposals.
New Jersey Enacts Standby Guardian Law
When a parent becomes afflicted with a terminal or progressively debilitating disease, providing for the future welfare of young children is a primary concern. The parent wants to ensure that the children are cared for in the future, but does not want to surrender his or her legal rights as a parent. Until now, there has been no way to accomplish this. The New Jersey Standby Guardianship Act, enacted earlier this year, fills this void. It permits a parent suffering from a progressive chronic condition or a fatal illness to designate a "standby guardian." If the parent later becomes unable to care for the child or children, the standby guardian shares parental authority with the parent. This process permits the parent to plan for a smooth transition in this extremely important area.
Independent Contractor Rules May Change
The determination of whether a worker is classified as an independent contractor or an employee of a business is often difficult. Current law requires the analysis of a multiplicity of factors. The Independent Contractor Tax Simplification Act, pending in the House, would streamline the rules. Because of the strong showing of support for this bill (it has over 100 sponsors), legislation on this topic appears likely.
Family Dispute Centers on Ownership of Life Insurance
The case of Mitzner v. Lights 18, Inc., recently decided by the New Jersey Supreme Court, is "a tragic case involving a disagreement between two brothers," according to one of the Court's Justices. Milton and David Mitzner co-owned a retail lighting business. The company purchased a $100,000 "key man" life insurance policy on each of the brothers to fund a buyout on death.The brothers had a falling out that resulted in a family lawsuit. The case was settled by an agreement that Milton would "buy the business [from David] for $65,000." The settlement agreement made no mention of the life insurance policies. After the sale was completed David, who had become seriously ill, sought ownership of the policy on his life. Milton refused, asserting that the policy was one of the assets of the corporation that he had purchased.
David argued that the purchase of the business was not intended to include the life insurance policy on his life. The policy was intended to fund a buyout, which had already occurred. Besides, it would be unfair for Milton to receive not only the business but also $100,000 in life insurance proceeds for a mere payment of $65,000. The majority of the court disagreed, and held that the settlement clearly encompassed all assets of the corporation, including the life insurance policies.
Comment: Planning the source of funding for a buyout is a common aspect of forming a business. As this case illustrates, life insurance planning must also be considered in the dissolution of a firm.
Well Said
"The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing."
- J.B. Colbert, Controller-General for Louis XIV
"To tax and to please, no more than to love and to be wise, is not given to men."
- Edmund Burke
"Idleness and pride tax with a heavier hand than kings and parliaments. If we can get rid of the former, we may easily bear the latter."
"The avoidance of taxes is the only intellectual pursuit that carries any reward."
- John Maynard Keynes
"What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin."
"The income tax has made more liars out of the American people than gold has."
"I'm proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money."
- Arthur Godfrey
FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It is not intended as and does not constitute legal advice, nor does it create an attorney-client relationship. The information contained in this publication should not be acted upon without first obtaining the advice of a professional advisor.
Copyright 1995 De Maio & De Maio. Permission is granted to reproduce and redistribute this newsletter for noncommercial purposes PROVIDED that 1) the entire newsletter, including this copyright notice, is reproduced without alteration, and 2) no fee or other charge is imposed.
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