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Taxing Problems: When to cash in Savings Bonds for students

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Q: We bought U.S. Savings Bonds for my daughter when she was born, and she also received EE bonds as gifts. Now that she is in her freshman year at college, we want to use the bonds to pay for tuition. Should she cash in all the bonds this year? Isn’t the interest tax-exempt if the money is used to pay for college? A.R.S., Massachusetts

A: The tax exemption you refer to is extremely limited, and you don’t appear to qualify. But it still may be a good idea to redeem some or all of the bonds.

Generally, interest on Series EE S bonds is taxable when the bonds are cashed in or they mature, whichever comes first. Alternatively, you can elect to pay taxes on the accrued interest on an annual basis.

The interest on U.S. Savings Bonds may be exempt from federal income tax if the funds are used to pay for qualified higher education expenses, but the exclusion applies only if:

  • The bond is a Series EE or I bond issued after 1989.

  • The owner was at least 24 years old when the bond was bought.

  • A child is not listed as a co-owner of the bond.
Bonds bought by a parent and issued in the name of a child under age 24 do not qualify. Also, in your case, it’s likely that the bonds were bought before 1990. Finally, this special tax exemption phases out at relatively low income levels. For 2006, the phaseout occurs between $63,100 and $78,100 of modified adjusted gross income for unmarried filers; between $94,700 and $124,700 for joint filers.

Nevertheless, it may make sense to cash in Savings Bonds in a child’s name when he or she is in a low tax bracket. You can use the funds for tuition even though you don’t qualify for the tax break for higher education. And you can reduce the tax bite if you spread the redemptions over several years.

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