ASK KIM
Make a Tax-Free Switch Out of Savings Bonds
by Kimberly Lankford

One of the vehicles I've used for saving for college is U.S. savings bonds. Over time, my income level has approached the limit at which I would no longer receive the advertised tax-free benefits if used them for college. Is there any way -- since I started buying the bonds because of the very advantage I will now be losing -- that I can still realize the benefit or roll the funds into another vehicle and maintain the benefit?

As long as you haven't passed the savings bond income thresholds yet, and your child will complete college by 2010, there is one way to maintain your tax-free status.

These income limits can definitely hurt if you're using savings bonds for college -- the interest is only tax-free for college tuition if your adjusted gross income stays below $119,750 if you're married or $74,850 if you're single (the amount you can exclude from taxes starts to phase out for married couples earning more than $89,750 or singles earning more than $59,850). These trigger points, which increase a bit with inflation each year, apply to the year you cash out the bonds, not the year you buy them.

Also keep in mind that the tax break only applies to series EE bonds issued after 1989 or series I bonds, and you need to be at least 24 years old on the bond's issue date (bonds in the kid's name don't count). You can only get the tax break for college tuition and fees, not room and board.

But you may have a small window of time to use as your escape hatch. You can make a tax-free switch from your savings bonds to a 529 college-savings account, which will let you use the money tax-free for college costs no matter how much you earn. Unfortunately, the federal tax-free status for 529s is only scheduled to last until 2010 unless Congress extends the benefit. If you're still paying college bills after that, withdrawals of your 529 earnings could be taxed at your beneficiary's normal income tax rate.

You can only make the tax-free switch in a year when your income falls below the cut-off for the savings bond tax break. So it's a good idea to move the money now if your income is increasing but hasn't yet reached the limit, or in a year when you have an unusually low income -- such as if one parent was unemployed or stayed home with the kids.

For more information about various tax breaks you can get for paying college bills, see IRS publication 970 Tax Benefits for Education. For a list of our favorite 529 plans, see our State College Savings Plan information page.