Are Savings Bonds the Best Route to College?
Q: I have heard that U.S. Savings Bonds proceeds will not be taxed if the money is spent on a college education. I would like to partially fund my daughter’s college tuition by purchasing bonds for her every year. She is now a year old. Is this the smartest way to invest for her education? --J.L.
A: Certainly you can’t go wrong buying U.S. Savings Bonds. They are absolutely safe, require no commission fees and can be regularly purchased in small denominations. Further, as you may know, middle- and lower-income taxpayers who use savings bonds for their children’s college education don’t have to pay federal income tax on the bond proceeds. (Savings bonds have traditionally been exempt from state taxes.)
However, the real question is whether you can do just as well in a “double-tax-free” money market account. These accounts invest in California municipal bonds, and although they typically carry a lower interest rate than regular money market accounts, their interest is exempt from both state and federal taxes.
The issue facing parents saving for a college education is timing. You have about 17 more years before your daughter enters college. U.S. Savings Bonds don’t reach their face value for about 12 years, so you can buy bonds for the next 10 years and hold them. Unless your daughter plans to earn advanced degrees--and it’s doubtful you’ll know that as she’s entering the first grade--any bonds you buy after 2003 either must be redeemed before reaching full maturity or won’t be entitled to a tax-free redemption.
Bonds are now earning 5.04% interest--it adjusts every six months--and bonds held at least five years are guaranteed a minimum 6% interest rate. Most double-tax-free money market accounts aren’t now paying higher interest rates. But then again, money market accounts have no minimum required holding period. When you want your money you can take it. However, you should know that money market accounts carry no federal deposit insurance. Although these accounts have performed very well over the years, there is no guarantee you will get back all you put in.
In the end, it boils down to your personal preference. You may find savings bonds preferable because they’re harder to dip into than a money market account and will therefore keep you honest about your savings plan. Many money market funds also have minimum deposit rules that can be prohibitive to the small saver. Also, it’s hard to beat the payroll deduction plan that many companies offer for Savings Bonds. However, if your income is high, you are probably not eligible to take advantage of the tax break offered by the College Saver plan.
No matter what you choose to do, you should think about these matters carefully. If you choose to continue buying Savings Bonds, you should know that bonds purchased for the College Saver plan must be registered in your name, not your child’s.
And whether you are eligible for the tax break will depend on whether you meet the applicable income ceilings when you redeem the bonds. Taxpayers filing single returns are now entitled to a full tax break on the bond proceeds if their adjusted gross income is less than $44,150. Single filers with an adjusted gross income of between $44,150 and $59,150 are entitled to a partial and gradually declining tax break. Couples filing joint returns must have an adjusted gross income of less than $66,200 to take advantage of the full tax break. Partial tax breaks are available for couples with adjusted gross incomes between $66,200 and $96,200. These limits are adjusted annually by a cost-of-living index.
Calculating Tax on Life Insurance Policy
Q: I recently surrendered my whole life insurance policy for its cash surrender value. I received a lump-sum payment. How do I figure my tax liability? -- R.T.
A: Simply deduct your premium payments from your total proceeds. The remainder is subject to ordinary income taxes.
Your insurance company should send you a form 1099 for the year in which you received the proceeds of the policy. The 1099 will tell you what your tax obligation is.
Tax Liability on Sale of Vacant Lot
Q: My sister and I own a vacant lot as joint tenants. We are planning to sell it and understand that we may have to take back a first trust deed in this market. That is no problem. However, how do we figure our tax liability for the sale?
Do we pay upon completion of the sale or when the note is fully repaid? --D.M.M.
A: First, let’s make a couple of key assumptions. No. 1: We assume that the land is fully paid for and you have no outstanding mortgage. No. 2: We assume that you and your sister are not a formal partnership and have not filed a partnership tax return for the land.
With these understandings, you should compute your tax obligation for the sale over the life of the loan. At the same time, however, you must amortize your cost for the property--your taxable basis--over the repayment period.
Here’s how it would work:
Let’s say you bought the property for $2,000 and sell it for $10,000. Twenty percent of the price is the return of your initial investment and the remaining 80% is your gain.
Now let’s say the buyer puts down $1,000 and agrees to pay the remaining $9,000 over the next five years. The $1,000 down payment must be apportioned between your return of capital (20%) and your gain (80%.) This gives the two of you a total reportable gain of $800 from the down payment, which should be divided equally between you and your sister. Subsequent payments on the loan principal are subject to the same 80-20 split.
However, this formula covers only the loan principal. Interest payments are entirely taxable as ordinary income.
