Publication 970: Tax Benefits for Education; Education Savings Bond Program

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Table of Contents

Important Change for 2003

Income limits for exclusion reduction increased. . For 2003, the amount of your interest exclusion will be phased out (gradually reduced) if your filing status is married filing jointly or qualifying widow(er) and your MAGI is between $87,750 and $117,750. You cannot take the deduction if your MAGI is $117,750 or more. For 2002, the limits that applied to you were $86,400 and $116,400. For all other filing statuses, your interest exclusion is phased out if your MAGI is between $58,500 and $73,500. You cannot take the deduction if your MAGI is $73,500 or more. For 2002, the limits that applied to you were $57,600 and $72,600. See Effect of the Amount of Your Income on the Amount of Your Exclusion, later.

Introduction

Generally, you must pay tax on the interest earned on U.S. savings bonds. If you do not include the interest in income in the years it is earned, you must include it in your income in the year in which you cash in the bonds.

However, when you cash in certain savings bonds under an education savings bond program, you may be able to exclude interest from income.

You may be able to cash in qualified U.S. savings bonds without having to include in your income some or all of the interest earned on the bonds if you meet the following conditions.

Qualified U.S. savings bonds.

A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must be issued either in your name (as the sole owner) or in the name of both you and your spouse (as co-owners).

The owner must be at least 24 years old before the bond's issue date. The issue date is printed on the front of the savings bond.

The issue date is not necessarily the date of purchase — it will be the first day of the month in which the bond is purchased.

Qualified education expenses.

These include the following items you pay for either yourself, your spouse, or a dependent for whom you claim an exemption.

Tuition and fees required to enroll at or attend an eligible educational institution. Qualified education expenses do not include expenses for room and board or for courses involving sports, games, or hobbies that are not part of a degree or certificate granting program.
Contributions to a qualified tuition program (QTP) (see chapter 8).
Contributions to a Coverdell education savings account (ESA), formerly known as an education IRA (see chapter 7).

Adjusted qualified education expenses.

You must reduce your qualified education expenses by all of the following tax-free benefits.

Tax-free part of scholarships and fellowships (see chapter 1).
Expenses used to figure the tax-free portion of distributions from a Coverdell ESA (see chapter 7).
Expenses used to figure the tax-free portion of distributions from a QTP (see chapter 8).
Any nontaxable tax-free payments (other than gifts or inheritances) received as educational assistance, such as:
1. Veterans' educational assistance benefits (see chapter 1),
2. Qualified tuition reductions (see chapter 1), or
3. Employer-provided educational assistance (see chapter 11).
Any expenses used in figuring the Hope and lifetime learning credits (see chapters 2 and 3).

Eligible educational institution.

An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

Dependent for whom you claim an exemption.

You claim an exemption for a person if you list his or her name and other required information on line 6c, Form 1040 (or Form 1040A).

Modified adjusted gross income (MAGI).

For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return without taking into account this interest exclusion.

MAGI when using Form 1040A.

If you file Form 1040A, MAGI is the AGI on line 22 of that form figured without taking into account any savings bond interest exclusion and modified by adding back any:

Exclusion for adoption benefits received under an employer's adoption assistance program,
Deduction for student loan interest, and
Deduction for tuition and fees.

MAGI when using Form 1040.

If you file Form 1040, your MAGI is the AGI on line 35 of that form figured without taking into account any savings bond interest exclusion and modified by adding back any:

Foreign earned income exclusion,
Foreign housing exclusion,
Foreign housing deduction,
Exclusion of income for bona fide residents of American Samoa,
Exclusion of income from Puerto Rico,
Exclusion for adoption benefits received under an employer's adoption assistance program,
Deduction for student loan interest, and
Deduction for tuition and fees.

Use the worksheet in the instructions for line 9, Form 8815, to figure your MAGI. If you claim any of the exclusion or deduction items (1) – (6) listed above, add the amount of the exclusion or deduction to the amount on line 5 of the worksheet. Do not add in the deduction for (7) student loan interest or (8) tuition and fees. Enter the total on Form 8815, line 9, as your modified AGI.

Because the deduction for interest expenses attributable to royalties and other investments is limited to your net investment income, you cannot figure the deduction until you have figured this interest exclusion. Therefore, if you had interest expenses attributable to royalties and deductible on Schedule E (Form 1040), Supplemental Income and Loss, you must make a special computation of your deductible interest without regard to this exclusion to figure the net royalty income included in your modified AGI. See Royalties included in modified AGI under Education Savings Bond Program in chapter 1 of Publication 550.

If the total you receive when you cash in the bonds is not more than the adjusted qualified education expenses for the year, all of the interest on the bonds may be tax free. However, if the total you receive when you cash in the bonds is more than the adjusted expenses, only part of the interest may be tax free.

To determine the tax-free amount, multiply the interest part of the proceeds by a fraction. The numerator (top part) of the fraction is the adjusted qualified education expenses you paid during the year. The denominator (bottom part) of the fraction is the total proceeds you received during the year.

Example.

In February 2003, Mark and Joan Washington, a married couple, cashed a qualified series EE U.S. savings bond they bought in November 1994. They received proceeds of $9,000, representing principal of $6,000 and interest of $3,000. In 2003, they paid $7,650 of their daughter's college tuition. They are not claiming a Hope or lifetime learning credit for that amount, and their daughter does not have any tax-free educational assistance. Their MAGI for 2003 was $80,000.

$3,000
interest

$7,650 expenses
$9,000 proceeds

$2,550
tax-free
interest

They can exclude $2,550 of interest in 2003. They must pay tax on the remaining $450 ($3,000 - $2,550) interest.

The amount of your interest exclusion is gradually reduced (phased out) if your modified adjusted gross income is between $58,500 and $73,500 (between $87,750 and $117,750 if your filing status is married filing jointly or qualifying widow(er)). You cannot exclude any of the interest if your modified adjusted gross income is equal to or more than the upper limit.

Use Form 8815 to figure your education savings bond interest exclusion. Enter your exclusion on line 3 of Schedule B (Form 1040), Interest and Ordinary Dividends, or Schedule 1 (Form 1040A), Interest and Ordinary Dividends for Form 1040A Filers. Attach Form 8815 to your tax return.

The information is the same as in the previous example for Mark and Joan Washington, except they have a modified adjusted gross income of $104,400. In this example, they can exclude $1,135 (line 14 of Form 8815 shown on the next page) of interest in 2003.

They must pay tax on the remaining $1,865 interest ($3,000 total interest minus $1,135 excluded interest).