Can you use I Bonds to pay for your grandchildren's college education tax-free? In this episode of Friends Talk Financial Planning, John Scherer and Bridget Sullivan Mermel discuss a strategy to do just that.
While I Bonds can be cashed out tax-free for your own or your dependent's college expenses, using them for grandchildren's education isn't as straightforward. However, there is a path to make it work:
1. Cash out the I Bonds and contribute the funds to a 529 plan in your own name. This qualifies as a tax-free event.
2. Change the 529 plan beneficiary to your child (the parent of your grandchild).
3. Your child can then change the 529 plan beneficiary to your grandchild.
The 529 funds can be used tax-free for the grandchild's qualified education expenses. John and Bridget discuss some additional considerations and variations, such as gifting, to navigate this process.
The key takeaway is that while this strategy may not fit every situation, knowing the possibility exists allows you to explore options to best fund your grandchildren's education with your available resources.
Tune in to learn more! And if you're looking for a fee-only financial planner, check out acplanners.org.
- Alliance of Comprehensive Planners: https://www.acplanners.org
- John's firm website: https://www.trinfin.com
TRANSCRIPT:
John: If you own an I bond and want to pay for college for yourself, you can cash that I bond out with no taxes. But what if you own an I bond and you want to pay for your grandchildren's education? Is there a way to do that? That's what we're going to talk about on today's episode of Friends Talk Financial Planning. Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. We're trying to get to a thousand subscribers, so if you wouldn't mind, please subscribe. It helps other people find us and helps support our channel. Okay, John, you've come up with this great strategy about how to take I bonds that you might have and transfer them to your grandkids, which is not a one-step deal. So let's talk benefits first. So tell me what the benefits are.
John: Yeah, maybe I'll start at the beginning. As I was teaching a retirement class over at the local community college, and we were talking about safe investments, and I bonds came up as one of those. As long-time viewers know, Bridget and I both really like I bonds and use them a lot in the right situations for clients. So this couple said, “Hey, we've been saving up. We've understood this I bond thing, and we've done it for a few years. We got some money in there.”
And the guy said, “As I understand, if I wanted to use it for college, I could do that, but it has to be used for either me or my dependent. And my grandchild is not my dependent. Is there a way I can avoid taxes and use this money for my grandkids?” So that's where this whole thing started. I thought, “Geez, that sounds kind of interesting.” So I dug into a little bit about. And as you probably do in your practice, Bridget, there're these ideas, there's these planning things, and then you don't use it for every client.
But it's about knowing what things are out there, so you can go dig and find out what the specifics are. So maybe to start with that. Using I bonds and some EE bonds for college expenses can be tax free. This means if you put in $10,000 and it grows to $12,000 or $15,000 I take all that money out and don't pay taxes on any of the gains, if I meet certain requirements. I had to have bought the bond when I was over 24 years old. I have to use it for college expenses, and then there's an income limit. And basically, if you're a married couple, once you get over about $150,000 or so of income, then you have to pay taxes on those I bond cashing out.
But if you're under that, then you can use the I bonds to pay for college for you and for your kids. It's really clear that there's no taxes on that. We talked in a recent episode about how to use I bonds as you approach retirement to develop cash. Similarly, this might be something for people to think about if your children are five years or so from college, and you can't afford a lot of fluctuations in your savings. That could be another place where the I bonds might fit in a portfolio.
Bridget: Okay, but you're talking about for grandkids.
John: That's right. For kids, there's a spot for this. Now, this is grandma and grandpa in their seventies, and they go, “The grandkids are going to college. I've got these I bonds, and they've gotten some really great interest over the years. Do I have a chance to use these for the kids’ college and not have to pay taxes on that?” And so, there's sort of a loophole. I don't know if loophole is the right word, but there's a path to get there.
Directly, I can't do this. I can't take that I bond, cash it out, and pay for my grandchild's education. That doesn't meet the exception or the tax-free rules. But what does meet the tax-free rules is under the education savings bond program that says if I pay for college expenses the cash out of the bond is tax free, one of the qualifying expenses is contributions to a 529 plan.
Bridget: Okay.
John: So I can put money in that. And now we're still not giving it to the grandkids yet. It’s just the idea that this is for grandma and grandpa, this is for mom and dad, this is for the kids, this is for you. For me, I've got an I bond. If I'm going to college, I can pay for college tax free. I can also put it into a 529 plan for myself tax free. So what grandma and grandpa do is they say, “Let's take our I bonds, set up a 529 account for us.” Even though we're 72, we can set up a 529 account; anybody can set up a 529 account. And we cash out those I bonds and put them into the 529 account for me. That qualifies for that exception. That's a tax-free event.
Now, I've got a 529 plan that owns what used to be my I bonds, and I'm the beneficiary. But what the 529 plan lets me do is I can then change the beneficiaries. And there's a list of people who qualify. And basically it's close relatives: kids, parents, etc. It can go up, it can go down, it can go to siblings first cousin, steps, aunts and uncles. There's a list of things that you can find. And you go, “I can change the beneficiary.” As we were getting ready for this, we're kind of taking a look at that list. One of the things that's not on there is grandkids. Grandparents are going up, but grandkids going down.
I'm not sure if that was a typo in the source we're looking at or not. But for sure, I can change the beneficiary from me to my kid, who's the parent of the grandchild, and then they can change the beneficiary to the grandkid. So we can do a twostep process or, perhaps, a one step process. But in any event, that's how we can get that money to our grandchildren. The 529 money goes to the kids who can then use it for their college things and room and board, even other things, all tax free. So that's sort of following the path, but the rules are set up, and by following those, you can get into a spot where you're using that I bond money tax free for college for your grandkids.
Bridget: Makes sense. And the one thing I would say is my understanding with 529s is that there's the owner and the beneficiary, and the owner can change the beneficiary, but the beneficiary can't change the beneficiary. That's my understanding, but I haven't done this particular transaction, and I'm sure parents wouldn't have a problem changing it to the kids, even if a beneficiary can change beneficiary.
John: And there's other things. We could get into those, too. I appreciate that. One of the things to think about is what are you trying to accomplish? We're not trying to make something up. We're trying to follow the rules on these things. So do your research on this. Figure out what the best way to do this is. One of the other things that you can do with these is also make gifts. We're talking about changing beneficiaries, but depending on the amounts that are in there, I can just make a gift, and I can gift the ownership to somebody else. So there's different ways that you can get to that.
Bridget: You're talking about with I bonds?
John: You can gift the I bonds. You can gift the 529 plans. Then there's gift tax rules. So once you get over $20,000 or so per person per year, then you get more rules. So if you have, you know, $5,000, $10,000 in an I bond, maybe it's easier just to make a gift of that. There’re some other things. Once you start getting some bigger numbers, that's when you should probably consult with somebody to make sure you're dotting the i's and crossing the t's. But there are some other places, too.
And like so many of our financial planning strategies, it's not one size fits all, but knowing that it's a possibility is key. That's the thing to think about. It's not a closed door, but there're some other things that you should think about. And this 529 idea is not saying, “Go out and do this.” It's more like saying, “Hey, I should explore this and try to figure out if this makes sense,” if that's what your goal is for things.
Bridget: Right. First of all, I love this. Here's a path. This is something that is doable. But my radar is up, because if I happen to have I bonds and want to fund my grandkids education, that’s great; here's where I can take the money from. But if I'm going to put money in I bonds with the intent of having a 529 in 20 years, that’s not so great. It's more like saying, “Oh, look at where I am right now. How can I best help pay for my grandkid’s college.” And here're some hoops that we're talking about going through versus talking about that as a strategy in order to help fund your grandkids education.
John: Right. That's such a great reminder. And sometimes it's easy to sort of get pigeonholed, thinking, “I'm saving this money for that purpose.” And sometimes we talk about the envelope or the bucket theory like that. It absolutely works. But then there’re other times when it’s not so rigid. Sometimes we should say, “When we get to that spot, we'll figure out where the best place to take the money for retirement, for paying for college education, for other things.”
Here's the situation. What's the best place to take this? And that really is the takeaway. Here's an option that we might want to investigate. If we already have I bonds, maybe we can use some of those things in a non-traditional way. So it’s about being aware of what’s out there, of things you could explore. It’s not about doing it for that purpose. It's got to be part of that bigger plan.
Bridget: Right. It seems like that's a great place to wrap it up. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Bridget and I are both taking on new clients at our practices, but we're also both members of the Alliance of Comprehensive Planners, so if you like the way that we think about financial planning and would like to find an advisor in your area, you can check out acplanners.org.
Bridget: And don't forget to subscribe.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.