ibonds and 529

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
ThisTimeItsDifferent
Posts: 246
Joined: Sat Jan 31, 2015 2:51 pm

ibonds and 529

Post by ThisTimeItsDifferent » Fri May 17, 2019 12:41 am

I understand that one can redeem tax deferred i-bonds and, if one meets the income limits, put the proceeds in a 529 and deduct the i bond interest, effectively making the interest non-taxable.

I also understand that one can withdraw from a 529 for non-educational expenses and pay taxes and a 10% penalty on the gains, but the withdrawal amount attributable to contributions (tax basis) are non-taxed and non-penalized.

Further I understand that one can now treat each 529 separately with respect to tax basis. Withdrawals are now pro-rata only within that account. It used to be they were pro-rata across all 529's (of that owner?)

What stops one from redeeming tax deferred i-bonds putting them in a 529, taking the deduction for the i-bond interest (making the interest non-taxable) then withdrawing the entire amount from the 529 and legally not paying taxes on any of it? Is the tax basis of the i-bond preserved when put into a 529? I see nothing that says it is....

Have I missed something?

User avatar
HueyLD
Posts: 7239
Joined: Mon Jan 14, 2008 10:30 am

Re: ibonds and 529

Post by HueyLD » Fri May 17, 2019 8:36 am

Yes, you missed the essence of such transfers.

Take a look at Form 8815, and more importantly read the instructions. You will learn that the I bond interest is not "deducted;" rather, it is excluded. They are not the same.

In addition, the exclusion will only defer the taxation of the interest until such a time that you withdraw the money from QTP for qualified education expenses (QEE). When you transfer savings bond redemption proceed to a QTP, it will ask you to break out (and provide proof for) the principal and the interest portion. In other words, the interest so transferred remains interest until you withdraw the money for QEE. Should you make non-qualified withdrawals, the penalty will apply to the interest portion.

Spirit Rider
Posts: 11935
Joined: Fri Mar 02, 2007 2:39 pm

Re: ibonds and 529

Post by Spirit Rider » Fri May 17, 2019 10:04 am

@HueyLD, The sole purpose of reporting the interest on Form 8815 is for the purpose of calculating a proration of the interest eligible for exclusion if the full savings bond redemption was not used for qualified educational expenses including 529 contributions. All 529 contributions are are cash contributions and only earnings within the 529 are considered for purposes of non-qualified distributions.

However, a contribution to a 529 plan, use of the Educational Savings Bond interest exclusion and then taking a 529 non-qualified distribution, is the very definition of a step transaction. You are doing this purely for the purposes of tax evasion and would be very clear in an isolated account.

It probably would not be a problem if you made the contribution and took the interest exclusion for a 529 account with other normal contributions. Then took substantial qualified distributions on behalf of the beneficiary and later took non-qualified distributions.

Topic Author
ThisTimeItsDifferent
Posts: 246
Joined: Sat Jan 31, 2015 2:51 pm

Re: ibonds and 529

Post by ThisTimeItsDifferent » Fri May 17, 2019 4:33 pm

Thanks for the information, that while the individual operations are as I thought, performing them together might be problematic, at least in the absence of other 529 contributions and or distributions.

I'm not sure I (or anyone) understand what qualifies as a step transaction or substance over form operation and what does not, or how to determine that. How is this distinguished from a backdoor Roth, for example which seems accepted in Summa Holdings
viewtopic.php?f=2&t=211297? Is it that the pro-rata rule makes backdoor Roth and direct Roth different for some people? Is it that the 5 year withdrawal rules are different? Maybe that is just a rhetorical question.

Does it matter if one contributes the ibond proceeds into an existing 529 or its own, especially if the pro rata rules are now by account?

Does the order of contributions and distributions matter?

Do changes in owner or beneficiary of the 529 matter?

Does the time lag between contributions and distributions matter?

All of these?

Here is a list of requirements in general to make the ibond redemption/ 529 contribution tax free.
https://www.fastweb.com/financial-aid/a ... vings-plan

Only bonds issued in 1990 or a later year qualify for tax-free treatment.

The child (or self?) must be listed as a beneficiary on the bonds, not as an owner or co-owner.

The bond owner must claim an exemption for the beneficiary on his/her federal income tax return.

The bond owner must have been at least 24 years old when the bonds were issued.

The bond owner must have modified adjusted gross income under the income phaseouts noted above.

The tax exclusion is not available to married taxpayers who file separate returns.

Spirit Rider
Posts: 11935
Joined: Fri Mar 02, 2007 2:39 pm

Re: ibonds and 529

Post by Spirit Rider » Fri May 17, 2019 9:53 pm

ThisTimeItsDifferent wrote:
Fri May 17, 2019 4:33 pm
I'm not sure I (or anyone) understand what qualifies as a step transaction or substance over form operation and what does not, or how to determine that. How is this distigushed from a backdoor Roth, for example which seems accepted in Summa Holdings
viewtopic.php?f=2&t=211297? Is it that the pro-rata rule makes backdoor Roth and direct Roth different for some people? Is it that the 5 year withdrawal rules are different? Maybe that is just a rhetorical question.
You are correct that the step transaction doctrine is not easy to define. It is a judicial doctrine rather than law. A good analogy is reasonable compensation for S-Corp 2% shareholder-employees. It is hard to define exactly, but unreasonably low compensation is easier to see.

I never felt the Backdoor was a step transaction and the Summa Holding decision while not directly a Backdoor Roth decision, was similar in many of the facts.

The problem with what you described was its intentional multi-step process to directly and immediately engage in it solely for the purposes of tax avoidance.
Does it matter if one contributes the ibond proceeds into an existing 529 or its own, especially if the pro rata rules are now by account?
Contributing to its own plan is one of the steps in combination with the others that indicates an intent to avoid any taxes.
Does the order of contributions and distributions matter?
Any order other than Educational Savings Bond redemption with exclusion followed exclusively by non-qualified distributions should help.
Do changes in owner or beneficiary of the 529 matter?
It would depend on the specific facts and circumstances.
Does the time lag between contributions and distributions matter?
Not only the time, but whether any distributions from the Education Savings Bond contributions were used for qualified educational expenses and not just non-qualifed distributions.
All of these?
Absolutely. When everything is said and done. It is always the specific facts and circumstances.

Maybe it is a step transaction and maybe it isn't, but in my mind it is an order of magnitude further in that direction than a Backdoor Roth.

To paraphrase Justice Potter Stewart about obscenity, I can't define a step transaction, but I know it when I see the signs. As you originally defined your path and steps, it sure sounded like an intention to engage in form over substance solely for the purpose of tax avoidance.

Topic Author
ThisTimeItsDifferent
Posts: 246
Joined: Sat Jan 31, 2015 2:51 pm

Re: ibonds and 529

Post by ThisTimeItsDifferent » Fri May 17, 2019 11:07 pm

Thanks for the discussion!

The original example may have been an extreme case. It seems like if you already have a 529, have already made contributions to it, have a beneficiary likely to use it for college, have a beneficiary actually use some of it for college, and there is some left over, then even if there is a pro-rata calculation based on contributions, then the ibond matured value counts completely as contribution basis and seems highly unlikely to run afoul of the step doctrine/step transaction concerns based on any one or more of those factors. The more of those factors differ, the more problematic it is.

I realize none of this is legal advice, but I am trying to understand what is legal or permitted.

Here's an IRS link discussing the doctrine.
https://www.irs.gov/pub/irs-wd/0826004.pdf
Courts have applied three alternative tests in deciding whether to invoke the step transaction doctrine:

(1) the "end result" test, under which the transaction will be collapsed if it appears that a series of formally separate steps are really prearranged parts of a single transaction intended from the outset to reach the ultimate result, see King Enterprises, Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969);

(2) the "mutual interdependence" test, which focuses on whether "the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series," Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir.1980), cert denied, 450 U.S. 913 (1981); and

(3) the "binding commitment" test, under POSTS-153917-06 2 which a series of transactions is collapsed if, at the time the first step is entered into, there was a binding commitment to under take the later step. See Commissioner v. Gordon, 391 U.S. 83, 96 (1968).
I don't see test 2 or 3 applying. One could contribute to and use a 529 plan as an adult for continuing education even if not a full time or traditional student. There's no binding legal or contractual agreement to perform any subsequent steps. As for 1, what if you do intend something then change your mind, and how would you prove that or the IRS prove otherwise (another rhetorical question)? Like you said, they would have to look at the totality of the evidence. Nobody would want to be a test case though.

If the original example were considered a step transaction violation, then might the example discussed here also be one
viewtopic.php?t=258148 to allow use for or beneficiary change to a descendant of a niece, when that is not directly allowed?

https://www.savingforcollege.com/articl ... a-529-plan discusses a similar process and concludes it is not a step transaction.

I learn so much from the sages here!

User avatar
Mel Lindauer
Moderator
Posts: 29948
Joined: Mon Feb 19, 2007 8:49 pm
Location: Daytona Beach Shores, Florida
Contact:

Re: ibonds and 529

Post by Mel Lindauer » Fri May 17, 2019 11:20 pm

ThisTimeItsDifferent wrote:
Fri May 17, 2019 4:33 pm

The child (or self?) must be listed as a beneficiary on the bonds, not as an owner or co-owner.
This statement is incorrect. It should say that the child MAY be listed as the beneficiary but not as the owner or co-owner.
Best Regards - Mel | | Semper Fi

Spirit Rider
Posts: 11935
Joined: Fri Mar 02, 2007 2:39 pm

Re: ibonds and 529

Post by Spirit Rider » Fri May 17, 2019 11:32 pm

ThisTimeItsDifferent wrote:
Fri May 17, 2019 11:07 pm
The original example may have been an extreme case. It seems like if you already have a 529, have already made contributions to it, have a beneficiary likely to use it for college, have a beneficiary actually use some of it for college, and there is some left over, then even if there is a pro-rata calculation based on contributions, then the ibond matured value counts completely as contribution basis and seems highly unlikely to run afoul of the step doctrine/step transaction concerns based on any one or more of those factors. The more of those factors differ, the more problematic it is.

I realize none of this is legal advice, but I am trying to understand what is legal or permitted.
My meter went off when it was a direct line strictly for the purpose of tax avoidance. Good luck trying to understand what is legal. This is one of those cases where your gut is probably as good as any metric. The farther you get from that direct line, the more legitimate it seems..
If the original example were considered a step transaction violation, then might the example discussed here also be one
viewtopic.php?t=258148 to allow use for or beneficiary change to a descendant of a niece, when that is not directly allowed?
For a similar reason why I don't believe the Backdoor Roth was ever a step transaction, I don't believe changing the beneficiary and then changing it again is a step transaction. If Congress/IRS had wanted to limit beneficiary changes to be based only on the original beneficiary they could have said so. It is still fundamentally being used as a 529 plan.

You original gambit was purely a way to avoid paying Savings Bond interest and never using those assets for qualified educational expenses in the 529. At least I see a materially significant difference.

Topic Author
ThisTimeItsDifferent
Posts: 246
Joined: Sat Jan 31, 2015 2:51 pm

Re: ibonds and 529

Post by ThisTimeItsDifferent » Mon May 27, 2019 12:58 pm

Spirit Rider wrote:
Fri May 17, 2019 10:04 am
@HueyLD, The sole purpose of reporting the interest on Form 8815 is for the purpose of calculating a proration of the interest eligible for exclusion if the full savings bond redemption was not used for qualified educational expenses including 529 contributions. All 529 contributions are are cash contributions and only earnings within the 529 are considered for purposes of non-qualified distributions.
The bogleheads wiki implies that the principal basis is tracked when moving from ibonds to a 529.

https://www.bogleheads.org/wiki/529_pl ... _transfers
The 529 plan will require you to provide a breakdown of principle and interest of the bonds when you make the transfer. For savings bonds, this can be accomplished by sending the plan a copy of Form 8815 or a copy of the 1099-INT form you will have received from the institution that redeemed the bonds. Supplying this information to the 529 plan is critical. If the plan does not receive this breakdown between principle and interest, it will account the transfer as consisting entirely of earnings which are subject to income tax and a 10% additional tax if withdrawn as a non-qualifying withdrawal from the 529 plan. Principle is not taxed in a 529 plan withdrawal.

Post Reply