Paying for college with EE bonds and bright start and coverdell ESA

Question

We are just staring the college road. Our daughter registered for 1 class and paid for it with cashing a savings bond in 2019 but the class started in 2020. This is the first issue. TT is not letting her use her bond interest tax free. I assume this is because she is under 24? The 1098T was issued in her name and the interest from 1099 was issued in her name.

She was planning on taking a summer class as well and will go full time with a partial scholership fall of 2020, but trying to figure this all out before she registers for the summer class and fall as to not mess it up.

Going forward we have a few scenarios trying to figure out the best way to use the funds we have set aside for her.

1. how do we know if the savings bonds are owned by her, us or both? I have read the ownership makes a big difference in how taxes are calculated. If we are co owner or owner is it best that we cash the bonds and we pay for her college directly to the college.

2. Is it better to withdraw money from her bright start account and pay for the college that way? who has to withdraw and who has to pay the college so the 1098T is in the correct name?

3. Is it better to withdraw the money from her coverdell ESA acccount and pay college? who has to withdraw and who has to pay the college so the 1098T is in the correct name?

4. is it possible to cash the bonds that are not in the correct name and deposit them into one of her college funds to not have to pay tax on the interest?

Thanks for any help and direction hoping to plan the best way before making a wrong choice for next years taxes.

Hal_Al · Answer

Q. TT is not letting her use her bond interest tax free. I assume this is because she is under 24?

A. It's because the bonds were issue in her name. Those are not eligible. Reference: https://www.finaid.org/savings/bonds.phtml

Q. Is it possible to cash the bonds that are not in the correct name and deposit them into one of her college funds to not have to pay tax on the interest?

A. No. The bonds are not eligible for a rollover to a 529 plan for the same reason.

Bright Start is a 529 plan (QTP - Qualified Tuition plan). For most college purposes, an ESA and 529 are the same. Since a 529 has a little more flexibility, withdrawing the ESA first might be best.

For more detail, read on.

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Qualified Tuition Plans (QTP 529 Plans)

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q.
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q. You decide where you want the money sent and instruct the plan administrator to do so.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit, that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q.
Example:
$10,000 in educational expenses(including room & board)

-$3000 paid by tax free scholarship***

-$4000 used to claim the American Opportunity credit

=$3000 Can be used against the 1099-Q (usually on the student’s return)

Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360)

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip! When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.

***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution."