How to Redeem a Savings Bonds Without Paying Taxes

To redeem a series EE or I savings bond without paying taxes on all or some of the interest, you must pay qualified education expenses by the end of the same tax year the bond is redeemed. Qualified education expenses include tuition and fee payments to a college, vocational school or any other postsecondary institution that the U.S. Department of Education allows to participate in the student financial aid program. Contributions to a 529 plan or a Coverdell education savings account are also treated as qualified education expenses. A Coverdell is a tax-advantaged account that allows you to put away up to $2,000 per year and make future tax-free withdrawals to pay education expenses. Expenses are only qualified if they cover your own education costs, your spouse's or those of your dependents.

To exclude interest, your modified adjusted gross income, or MAGI, must be less than the threshold amount in effect for the year you redeem the savings bonds. The threshold amount can change each tax year. The Internal Revenue Service notes that for most people, MAGI is the same as adjusted gross income, or AGI. Adjusted gross income is the difference between the total earnings you report minus the specific deductions listed in the “Adjusted Gross Income” section of your return, such as for student loan interest, alimony payments and moving expenses. For the purpose of figuring out your MAGI to exclude bond interest, you increase AGI for certain tax items, such as the student loan interest deduction and the foreign earned income and housing exclusions.

The IRS uses a single fraction to determine how much, if any, of the interest from the redemption of your series EE and I savings bonds can be excluded from your taxable income. You can figure this out by multiplying the total amount of interest you receive by a fraction that uses the annual adjusted qualified education expenses, or AQEE, as the numerator and total bond proceeds as the denominator. The bank or other financial institution that redeems the bonds can tell you the interest amount. Total bond proceeds equal the bond's principal plus interest. Your AQEE is equal to total qualified education expenses minus other tax-free educational assistance received, such as scholarships and any tax-free withdrawals from Coverdell savings accounts and 529 plans you make.

If you're eligible to exclude bond interest from your taxes, you'll fill out Form 8815 to determine the precise amount that's tax free. Once Form 8815 is complete, the IRS also requires the excludable interest to be reported on Schedule B. Schedule B and Form 8815 both get attached to your return.