Savings bonds offer investment security and the ability to defer taxes on the interest income, and both features help make up for the generally lower rate of return. However, the only way to exempt the interest on Series EE savings bonds from income taxes is by spending the interest on educational expenses.
Even though savings bonds accrue interest each year, the interest is deferred until you cash in the bonds unless you elect to report the interest on your taxes each year. The deferral option allows you to put off paying taxes until you've received the cash from turning in the bond. In addition, you may be able to choose a year to cash in your bond when you have less other income; if you fall to a lower tax bracket, your savings bond interest is also taxed at a lower rate.
If your Series EE bond was issued after 1989 in your name or the name of you and your spouse and you're at least 24 years old, you might be able to cash in your savings bond and avoid income taxes on the interest if you spend the money on qualified educational expenses. To count, the expenses must be paid in the same year that you cash in the bonds. For example, if you pay your tuition in 2014 but don't cash in your bonds until 2015, you can't treat the interest as being used to pay for the previous year's expenses.
Qualified Educational Expenses
Not all school-related costs will get you off the hook for taxes on your savings bond interest. You must spend the savings bond interest on tuition or fees at a higher-education institution, such as a college, trade school or graduate school. You can also satisfy the requirement by contributing to a 529 plan or a Coverdell savings account. For example, if you cashed out your bond but won't go to graduate school until next year, you can contribute to a 529 plan to exempt the interest from income taxes.
If you qualify for the education exclusion of savings bond interest, you have a little extra work to do when you file your tax return. You report the savings bond interest as you normally would if it were taxable on Schedule B. Then you complete Form 8815 to report the amount you're able to exclude. This exclusion is copied over to Schedule B and subtracted from your taxable income, making the Series EE savings bond interest tax free.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."