Interest on U.S. savings bonds is normally subject to federal income tax. If the interest is not included in your income in the year it is earned, it must be included in income the year you redeem the bonds. But you may be able to exclude interest income on Series EE or I savings bonds if the proceeds are used to pay qualified education expenses at an eligible educational institution or a State tuition plan the year you redeem the bonds. There are several specific requirements that must be met in order to exclude this interest from your taxable income.
Who Is Eligible for Exemption of Interest?
In order to exclude interest, the bonds must qualify as education savings bonds. These are series “EE” bonds issued after 1989, and all series “I” bonds. And the owner must have been at least 24 years of age before the bond issue date. The issue date is the first date of the month in which the bond was purchased.
If the bonds are to be used for your child’s education, they must be in your name as the sole owner, or in the names of you and your spouse, as co-owners. Your child can be listed as a beneficiary on the bond, but not as a co-owner. If the bonds are for your own education, they must be registered in your name. Bonds that were originally purchased in your child’s name can be re-issued in your name, provided the bonds were not purchased with the child’s money and were purchased after 1989. Bonds that remain in the child’s name do not qualify for exclusion of interest as education savings bonds, but the interest will be taxed at the child’s tax rate when the bond is redeemed, which could be lower than the parents’ rate.
In the year you redeem the bonds, your filing status must not be married filing separately. And there is a phase out of the interest exemption if your modified adjusted gross income is above a certain amount. It should be kept in mind that these limits apply to your modified adjusted gross income in the year you cash in the bonds, and not the year you purchase them. Interest would be partially excludible if your modified adjusted gross income is above the phase-out amount but less than the ceiling, at which no part of the interest from the bonds would be excludible. These phase-out amounts are different, depending on your filing status. Higher limits apply if you are married filing jointly or if you file as a qualifying widow(er) with dependent child. These limits on modified adjusted gross income are adjusted annually, and can be found in the instructions and publications the Internal Revenue Service (IRS) issues each year. You can find these amounts in IRS Publication 970, Tax Benefits for Education, which is available for viewing or downloading from the IRS website at www.irs.gov.
When you cash in the bonds, the proceeds must be used to pay qualified education expenses for yourself, your spouse, or a dependent for whom you actually claim an exemption on your federal income tax return.
Qualified Education Expenses
Tuition and fees required for enrollment or attendance at an eligible educational institution are qualified education expenses. Expenses for books, and room and board are not included. Expenses for courses involving sports, games, or hobbies do not qualify unless they are required as part of a program leading to a degree or other certificate. Qualified state tuition plans are considered qualifying education expenses.
Eligible educational institutions include practically all accredited public, private, and non-profit colleges, universities, vocational schools, and other postsecondary educational institutions that are eligible to participate in student financial aid programs administered by the U.S. Department of Education.
Qualified education expenses must be adjusted for any tax-free educational assistance benefits, including:
Ã?Â· The tax-free portion of scholarships and fellowships,
Ã?Â· Veterans’ educational assistance benefits,
Ã?Â· Qualified tuition reductions,
Ã?Â· Educational assistance provided by an employer,
Ã?Â· Other tax-free educational assistance benefits, other than gifts or inheritance,
For purposes of determining how much of the interest from the bonds can be excluded, qualifying education expenses must also be reduced by the expenses taken into account in figuring other tax benefits, including:
Ã?Â· Expenses used to determine the tax-free portion of a distribution from a qualified tuition program (QTP) or from a Coverdell education savings account (ESA), and
Ã?Â· Expenses taken into account in figuring the Hope and lifetime learning credits.
There are two other categories of “qualified education expenses” that are important to take into consideration. Contributions to a qualified tuition program (529 plan) or a Coverdell Education Savings Account (ESA) are included in the definition of qualified education expenses. So, if you cash in savings bonds and contribute the proceeds to either one of these plans in the same year, this qualifies as an education expense. Provided you meet the other tests, you would be able to exclude the interest on the savings bonds from your taxable income.
Modified Adjusted Gross Income
Modified adjusted gross income (MAGI) is adjusted gross income (AGI), before taking into account the savings bond interest exclusion; that is, your MAGI includes the interest from the redemption of the savings bonds. Certain other adjustments to income are also added back in determining MAGI, including:
Ã?Â· Exclusion of adoption benefits received from an employer,
Ã?Â· Deduction for student loan interest,
Ã?Â· Deduction for tuition and fees,
Ã?Â· Foreign earned income exclusion,
Ã?Â· Foreign housing exclusion or deduction,
Ã?Â· Exclusion of income for residents of American Samoa, and other U.S. possessions, and
Ã?Â· Exclusion of income from Puerto Rico.
Claiming the Exclusion
You claim the exclusion of interest on qualifying education savings bonds by completing and filing From 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989. If the total proceeds from your redemption of the savings bonds, including both principal and interest, is not more than your adjusted qualified education expenses for the year, all the interest may be excludible. But if your total proceeds from cashing in the bonds is more than your adjusted qualified education expenses, only part of the interest is excludible. The excludible portion of the interest would be based on the ratio of your adjusted qualified education expenses for the year to your total proceeds from the redemption of the bonds during the year.
There is a worksheet in the instruction for Form 8815 that can be used to determine your modified adjusted gross income. If your MAGI is within the phase-out range, the calculations on Form 8815 itself will determine the portion of the interest that you can exclude.
The amount of interest that can be excluded, as determined on Form 8815, is then reported on line 3 of Schedule B, Interest and Ordinary Dividends, if you file Form 1040, or on Schedule 1 if you file Form 1040A.
Form 8815 and the instructions, as well as IRS Publication 970, Tax Benefits for Education, are available for viewing and downloading from the IRS website at www.irs.gov.
You can purchase up to $30,000 a year in face value of either Series EE or I bonds, and up to $60,000 if you and your spouse are registered as co-owners.
Series EE Bonds
Series EE bonds are issued at 50% of their face value. Interest is calculated at 90% of the 6-month averages of the yields on 5-year Treasury Securities. Series EE bonds are guaranteed to reach maturity value in 17 years, giving them an effective annual minimum rate of return of 4.16%. The redemption value increases as interest accrues on the principal. Series EE bonds can be redeemed after six months, but there is an early redemption penalty, forfeiting three months of interest, if the bonds are redeemed within the first five years. Bonds can continue earning interest for up to 30 years.
Series I Bonds
Series I bonds are issued at full face value, and earn interest as a combination of a fixed rate of return and a semi-annual inflation rate adjustment based on the Consumer Price Index. Series I bonds are accrual-type securities, like the Series EE bonds, and their redemption value increases as interest accrues on the principal. And, like Series EE bonds, Series I bonds can be redeemed after six months, but with the same three months of interest penalty. And they can continue earning interest for up to 30 years.