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.
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-education 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.
- Only certain bonds allowed.
- Qualified institutions and expense.
- Phasing out the tax break.
- Paperwork and other filing requirements.
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.
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.
- 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.