The Internal Revenue Service allows taxpayers to exclude from their taxable income a portion of their interest payments on savings bonds. However, this is only if they use the interest payments to finance higher education for themselves and their dependents. Taxpayers can also claim the American Opportunity Credit if they are paying for the first four years of college. The IRS doesn't require taxpayers to choose one or the other, but claiming both can affect how much of the interest you can claim as tax free.
American Opportunity Credit
The IRS has replaced the Hope credit with the American Opportunity credit. This credit allows students, or their parents if the student is a dependent, to deduct up to $2,500 per year of qualified educational expenses during the first four years of education. You can claim this credit and the savings bond tax deduction if you do not use both to cover the same expenses. For example, if you have tuition of $10,000 you can claim a credit of $2,500 and use the savings bond interest on a different portion of the tuition. If your tuition is only $2,000, however, you cannot use both the deduction and the credit as they would both be used for the same purpose.
Type of Savings Bonds
To qualify for the tax deduction, you must cash in a Series EE or Series I savings bond and use it to pay for higher education expenses for you or your child. And you must do so in the same year that you cash in the bond. You cannot claim the deduction if you cash in a different type of bond, or if you save the money and use it for higher education expenses several years down the line.
Modified Adjusted Gross Income
Both the savings bond tax deduction and the American Opportunity Credit require students or their parents to have a modified adjusted gross income (AGI) of less than a certain amount. Your modified AGI must be less than $70,100 to take a full deduction. You must have a modified AGI of less than $90,000 ($180,000 if you are a married person filing jointly) to take the American Opportunity Credit.
The deduction for savings bond interest is more properly called an exclusion -- this amount of interest is not counted as income for tax purposes. If your savings bond interest is greater than the amount used for qualified educational expenses, you must divide the educational expenses by the total amount he receives from cashing bonds and multiply it by the interest earned to determine which portion is tax free. If you also claim an American Opportunity Credit, it may affect how much of your savings bond interest is tax free. You may use less of your bond income to pay for educational expenses due to the use of the credit.
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