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July 22, 2007 -- We have saved money for our child’s college education in U.S. Savings Bonds. Do we have to pay taxes on the interest earned on those bonds if they are used for college tuition and fees? How do we make it clear that the proceeds from the bonds are used for college expenses and therefore should not be taxed?

There are a variety of ways to save for your child’s education and receive tax benefits in the process. U.S. Savings Bonds and Tax-exempt bonds are two of the many investment choices available.

Series EE U.S. savings bonds. Series EE U.S. savings bonds offer two tax-savings opportunities when used to finance your child's college expenses: first, you don't have to report the interest on the bonds for federal tax purposes until the bonds are actually cashed in; and second, interest on “qualified” Series EE (and Series I) bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses.

To be eligible for the exclusion, the bonds must be issued after December 31, 1989, and be purchased by an individual who is 24 years of age or older. The age requirement precludes the child from owning the bonds; thus, the bonds must be registered in the name of the adult taxpayer or adult taxpayer and spouse. The exclusion is not available to the owner of a bond that was purchased by another individual (such as a gift from a parent).

Bond proceeds must be used to pay qualified higher education expenses of the taxpayer, spouse, or any dependent. These expenses typically include tuition and fees. The cost of books or room and board are not qualified expenses.

Qualified higher education expenses must be at eligible institutions and include transfers of redemption proceeds to a qualified tuition program for the designated beneficiary, or to an education savings account (ESA) on behalf of an account beneficiary who is either the taxpayer, his or her spouse, or dependent. The amount of qualified higher education expenses must be reduced by amounts received as scholarships, fellowships, veteran’s benefits, or other tax-exempt educational benefits, as well as expenses used to claim the Hope Scholarship Credit or Lifetime Learning Credit and qualified expenses paid with distributions from ESAs and 529 Plans. Eligible educational institutions include most public and nonprofit higher educational and postsecondary educational institutions.

To be eligible for the full interest exclusion you must be married filing a joint return or a single filer. Additionally, if your adjusted gross income (AGI) exceeds certain amounts, the exemption is phased out. For bonds cashed in during 2007, the exemption starts to “disappear” when your (joint) AGI hits $98,400 for joint return filers ($65,600 in for singles) and is gone entirely if your AGI is at $128,400 ($80,600 for singles). These figures are adjusted annually for inflation.

The amount of interest excludable is limited by the amount of redemption proceeds (interest and principal) used to pay education expenses in the same year as the redemption. This redemption limitation is calculated by dividing the qualified higher education expenses by the qualified U.S. savings bond proceeds.

The interest exclusion is reported on Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989.

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