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Bankrate's 2010 Tax Guide
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Cashing savings bonds can yield tax break

But when you eventually use these other savings to help pay for college, the amounts withdrawn could affect the tax savings offered by bonds. When figuring what you can pay with the bonds, the IRS says you must reduce the expenses by the amount of financial aid you get.

Reduce expenses if you get aid from:
  • Tax-free scholarships.
  • Nontaxable payments, such as veterans' educational assistance benefits, disbursements from state tuition programs or tax-free educational aid from an employer.

You cannot double dip. This means you cannot use bonds to pay expenses that you counted in figuring any American Opportunity, Hope or Lifetime Learning tax credits that you claimed or that were paid with tax-free Coverdell withdrawals.

Phasing out the tax break

If the savings bond amount you cash in is greater than the actual educational costs you paid, then you can't exclude all of the bond interest from taxes.

There also is a limit on how much bond interest is tax-free, depending on your income. On 2009 tax returns, single or head-of-household taxpayers who have modified adjusted gross income between $69,950 and $84,950 per year face a reduced tax exclusion. The range for married couples filing jointly is $104,900 to $134,900.

If you make more than the top salary amount for your filing status, interest on your savings bonds is fully taxable even when you use it for allowable educational expenses.

Filing and other paperwork requirements

Finally, to claim the interest exclusion on savings bonds used for school costs, you have to report everything in the proper manner to the IRS.

This break is not available to taxpayers who use Form 1040EZ. You must file Form 1040A or Form 1040 and, if married, file a joint return.

In addition, 1040A filers will have to complete Schedule 1; 1040 taxpayers must file Schedule B. In either case, you'll also have to fill out Form 8815 and attach it to your return.

The IRS recommends that you keep bills, receipts, canceled checks or other materials that show you paid qualified educational expenses in the year you claim tax-free bond interest. The agency also suggests you keep a written record of each bond you cash, showing the serial number, issue date, face value and total redemption proceeds -- principal and interest -- of each. The IRS has designed a form for this, Form 8818. You don't have to file 8818 with your tax return, but it does provide an easy way to track the data the IRS could ask for if it ever questions your savings bond tax break.

So if you're preparing to use savings bonds to pay college costs, do your tax homework and gather your documentation. It will help ensure that more of your money goes to pay for that B.A. instead of to the IRS.

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