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Bankrate's 2009 Tax Guide
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TAX TIP No. 66
'Educated' use of savings bonds earns tax break

U.S. savings bonds have always been a popular way to stash cash without a lot of risk. They also have a tax advantage: The interest they earn is free from state and local taxation.

In this tax tip:

Some taxpayers can get that same tax-free interest benefit on their federal returns. This is the case when the savings bonds are cashed to pay higher-educational expenses.

There are, of course, rules on what types of schools and expenditures are acceptable, as well as extra Internal Revenue Service paperwork to complete. And if you cash in a large amount of bonds or make a lot of money, you won't get the full benefit of this tax break.

But the effort could help lessen Uncle Sam's tax bite on the savings bond earnings you put to educational use.

Only certain bonds allowed
First, you must redeem the appropriate savings bonds to get the break: either Series EE or Series I bonds issued after Dec. 31, 1989.

The bonds must be issued in your name, or, if you are married, they may be issued in your name and your spouse's name. It does not matter who bought the bonds.

In either case, the bond owner (or owners) must have been at least age 24 when the bonds were issued. A bond bought by a parent, but put in the name of a child younger than 24, will not qualify for the exclusion.

Also be careful when determining the instrument's issue date. This is not the date the bond was purchased. A bond could have been bought after its issue date, which is printed on the front of the document.

Qualified institutions and expenses
You can use the bond money to pay schooling costs for yourself, your spouse or a dependent. But the expenses and the school to which they are paid must be "qualified" in the IRS's eyes to maintain the bond's tax-free interest status.

As with most education-related tax matters, the IRS accepts authorized payments to a college, university, vocational school or other post-secondary establishment that meets student-aid program guidelines administered by the U.S. Department of Education. This includes public, private and nonprofit institutions.

Qualified higher-education expenses paid by bond proceeds generally are limited to tuition and fees that are required for enrollment or attendance at the school. Room and board are not allowable expenses, nor are primarily recreational fees. This means you cannot count charges for courses involving sports, games or hobbies.

The IRS says it's OK to use savings bond money (and preserve the tax-free interest status) to contribute to a child's Coverdell education savings account (formerly called an education IRA) or to a qualified state-tuition program. Check with your state's particular tuition savings plan for its limits.

-- Updated: April 8, 2009
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