Education Savings Bonds Program
One exclusive benefit of United States savings bonds is the Education Tax Exclusion (26 USC § 135), which allows qualified taxpayers to redeem their bonds tax-free if the proceeds are used to pay for certain educational expenses at qualified institutions. For tax-free treatment, the redeemed bonds must be Series EE or Series I bonds issued after 1989 to someone at least 24 years old, and who is responsible for the college tuition, and the college tuition must be paid in the same year that the bonds are redeemed. The money cannot be used for books or for room and board.
- A married bondholder must file a joint return.
- Modified adjusted gross income (MAGI) must be less than a certain amount, adjusted annually for inflation, in the year when the bonds are redeemed, which is stipulated in Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989 that is used to claim the exclusion. The MAGI is equal to adjusted gross income before excluding any bond interest plus any exclusions for:
- non-taxable Social Security,
- IRA deductions,
- foreign earned income,
- income earned by bona fide residents of either American Samoa or Puerto Rico,
- adoption benefits from an employer's adoption assistance program,
- plus any deductions for:
Above those threshold amounts, the tax-free treatment starts phasing out, depending on filing status:
If MAGI exceeds the phaseout limit, then the entire redemption amount is taxable – there is no tax savings.
To calculate the tax-free portion of the educational bond redemption when the MAGI exceeds the threshold:
- Phaseout Reduction = Redemption Amount × (MAGI – Phaseout Threshold)/Phaseout Range
- Tax-Free Redemption Amount = Redemption Amount – Phaseout Reduction
|Eligible Redeemed Bond Principal + Interest||$10,000|
|Phaseout Reduction||$3,533||= Redemption Amount × (MAGI – Phaseout Threshold)/(Phaseout Limit – Phaseout Threshold)|
|Tax-Free Redemption Amount||$6,467||= Redemption Amount – Phaseout Reduction = $10,000 – $3,533|
Bond Redemption Requirements
- The educational expenses must be incurred in the same tax year the bonds are redeemed.
- By the 1st day of the month of the bond purchase, the bondholder must have been at least 24 years old.
- Redeemed bonds used to pay for a child's education must be registered in the name of a parent, and the child cannot be a co-owner or a secondary owner, but can be listed as a beneficiary.
- The bonds must be registered in the name of the bondholder to pay for his own educational expenses.
Qualified Education Expenses
Qualified educational expenses have the following requirements:
- The educational institution must qualify for federal assistance, such as for guaranteed student loan programs, which includes most colleges, universities, and vocational schools.
- The expenses must be for tuition and fees, such as lab fees and other required course expenses, but not books or living expenses.
- The expenses must benefit the bondholder, his spouse, or a dependent for whom the exemption is claimed.
- Any course expenses must be for courses required for a degree or certificate-granting program, so courses for sports, games, or hobbies do not qualify unless they are required for the degree.
However, qualified educational expenses must be reduced by the amount of any tax-free portions of scholarships, fellowships, employer-provided educational assistance, and other forms of tuition reduction, by the expenses used to calculate the tax-free portions of Coverdell ESA's and qualified tuition programs, then by any expenses used to calculate the American opportunity credit or the lifetime learning credit. This result yields the adjusted qualified education expenses (AQEE).
All of the principal and interest must be used to pay qualified expenses. If bond redemption proceeds are greater than the qualified educational expenses, then the amount of interest that can be excluded from income is reduced pro rata:
|Tax-Free Interest||=||Interest||×||Adjusted Qualified Education Expenses|
Total Bond Redemption Amount (Principal + Interest)
Taxable Interest = Interest – Tax-Free Interest
Example: If bond proceeds equal $10,000 ($8,000 principal + $2,000 interest) and the AQEE are $8,000, 80% of the earned interest, which would equal $1,600 (= .8 × 2000), can be excluded from income. The remaining interest of $2,000 – $1,600 = $400 is taxable.