Saving for College with U.S. Savings Bonds: Paying for Qualified Expenses

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If you're planning on using savings bonds to pay for college, you need to know what expenses are qualified for the purpose of redeeming these bonds tax-free. Remember that although U.S. Savings Bonds are safe and reliable, they're not particularly exciting when you look at how much money you can make with them. They become players when you can make that money and not pay any income tax.

In comparison to the definition of qualified educational expenses for Section 529 plans and Coverdell Education Savings Accounts, the expenses you may pay using tax-free redemptions of Series EE and/or Series I savings bonds are quite restrictive. Only postsecondary expenses qualify, and of those expenses, only the following are allowed:

• Tuition and fees to an eligible postsecondary educational institution: The school's ability to participate in federal financial aid programs administered by the U.S. Department of Education is the test here. Although you're not required to provide anyone with proof of what you include as qualified educational expenses, be sure that you can substantiate your claims. If the IRS comes calling and asks for your records, be certain that you can gently place those canceled checks or receipted tuition bills under the agent's nose.
• Payments into Section 529 plans or Coverdell Education Savings Accounts: You may already have purchased one or two or more Series EE or Series I savings bonds with the idea of using them for educational expenses, but you're watching your salary rise, and think that you may soon be earning more than is allowed in order to take advantage of tax-free redemptions.  Before this window closes, you may want to redeem those bonds, and invest all of your redemption funds into a Section 529 plan, a Coverdell account, or both.

You can't pay for room and board, books, supplies, and all the other great things that you're allowed to pay for by using distributions from Section 529 plans or from Coverdell accounts with tax-free savings bond redemptions.

Keep in mind, though, that whenever you redeem a bond, even if some of what you use it for is a nonqualified expense, you pay only the federal income tax on the income portion — no state tax, and no 10 percent penalty for a nonqualified withdrawal. So even if you don't get the tax exemption, you're still getting a pretty good deal.

You may not double dip. You may claim any qualified expenses that you have only in one place. If you make a qualified withdrawal from a Coverdell account or from a Section 529 plan to pay for certain expenses, you aren't allowed to also have a tax-free savings bond redemption to cover those same charges. You may, however, choose to pay some educational expenses from one savings plan, and others from another.

To further complicate matters, if you're planning on taking the Hope Credit or the Lifetime Learning Credit, you must pay for the qualified expenses that you assign to these credits with money you've paid tax on. If you're paying for expenses using Series EE or Series I savings bonds, you have to pay the income tax on the interest to be eligible for the credits.

Just as with Coverdell and Section 529, you must have actually paid these expenses to be able to exempt the income earned on these bonds from tax. If you received scholarships, veteran's educational assistance benefits, or qualified tuition reductions, you need to reduce the otherwise qualifying amounts by the tax-free assistance you receive.