Dear Dr. Don,
If I cash in savings bonds to pay off college loans, will I have to pay a penalty?
— Peter Penalty
You’re asking whether you can use savings bonds to pay off your college loans and have the interest earnings qualify for the education tax exclusion. You can’t. There’s no penalty, you’ll just owe income tax on the deferred interest earnings.
There’s also no interest penalty, unless you redeem a bond within the first five years of its issuance. In that situation, you lose the last three months’ of interest earnings as an early redemption penalty. Savings bonds can’t be redeemed in the first year of issuance, although the government makes an exception for disaster victims.
Beyond naming what qualifies as a higher-education expense, the education tax exclusion has income limitations and requirements as to how the savings bonds must be registered. You can learn more about it on the TreasuryDirect Web page, “Education Planning.”
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