Dear Liz: Please write a comparison of 529 college savings plans versus using I bonds for education. I had given baby gifts of 529 funds to grandkids before they had their first birthdays. But due to market volatility, this year I matched those with I bond funding for the kids. The oldest is now 6, so there is time to get past penalty issues for withdrawals should they use these for education, as I hope they will.
Answer: As mentioned in previous columns, 529 college savings plans are a flexible, tax-advantaged way to save for education costs.
Money can be used tax free for private kindergarten through 12th grade tuition as well as qualifying college expenses. Plus, up to $35,000 of leftover funds can be rolled over into a Roth IRA.
Accounts owned by parents have minimal impact on financial aid, and accounts owned by grandparents aren’t included in federal financial aid calculations at all.
College savings plans typically offer an array of investment options, including age-weighted funds that get more conservative over time. The ability to invest the money means you have a good shot at generating inflation-beating returns over time, but you also have to deal with some ups and downs in the markets.
I bonds — technically, I Series Savings Bonds — have advantages as well.
These are government-issued bonds, so you can’t lose your principal, and they are designed to help investors keep up with inflation. I bonds earn a fixed rate for the 30-year life of the bond, which is currently 0.4%, plus a semiannual variable rate pegged to inflation (currently 3.24%).
The composite rate formula for I bonds issued from November 2022 through April 2023 is 6.89%. In the previous 6 month period, bonds paid 9.62%.
The interest is added every six months to the bond’s value, rather than paid out, so bond owners can defer federal taxes until the bond is cashed in. (I bonds are exempt from state and local taxation.) And the interest can be tax free if the bond proceeds are used to pay for certain higher education costs.
Getting that tax-free treatment is somewhat complicated, however.
First, the bonds would need to be owned by the parents rather than you or the grandkids. Qualifying college expenses must have been incurred by the bond’s owner, the owner’s spouse or a dependent listed on the owner’s federal tax return.
There’s an age restriction too: The bond owner must have been at least 24 before the bonds were issued. The ability to get the exclusion ends if modified adjusted gross income is above certain limits (in 2022, it was $100,800 for singles or $158,650 for married couples filing jointly).
I bonds have other restrictions. No withdrawals are allowed in the first year of ownership. Any withdrawals made within the first five years trigger a loss of three months’ worth of interest income.
People can buy $10,000 of electronic I bonds each year, plus they can use their tax refunds to purchase an additional $5,000 of paper I bonds.
I bonds are certainly a reasonable alternative for college savings, but the various restrictions on their purchase and use may make 529 college savings plans a better option for many families.
Taxes on a deceased spouse’s assets
Dear Liz: My dear friend’s husband just passed away and she is immediately selling off all his antiques through an auctioneer. Sales should net well over $100,000 this calendar year. Is there any way to offset the tax hit she will take on this? This will be on top of selling the house in the same calendar year.
Answer: Previous columns have discussed the favorable “step up” in tax basis that happens when someone dies.
Their assets, including at least half of a jointly-owned home, typically get updated to the current market value for tax purposes. Appreciation that occurred during the deceased’s lifetime is never taxed. In community property states, both halves of jointly-owned assets usually get this step up.
The auction shouldn’t generate much if any tax bill unless the antiques jump significantly in value between the date of his death and the date of the sale.
The same is true of the home sale if the friend lives in a community property state. If not, she may have potentially taxable appreciation on her half of the property. If the sale occurs within two years after the year her husband died, though, she can exclude up to $500,000 of home sale profits from her income. Otherwise she can exclude up to $250,000.
Your friend should consult a qualified tax pro who can review her specific situation and offer individualized advice.
Liz Weston, Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.