Question

During the current year, a couple cashes in $10,000 of Series EE savings bonds to help pay the cost of their son's college education. Of this amount, $5,200 represents principal and $4,800 represents interest. They use $7,000 of the proceeds to pay for tuition and the rest to cover their son's room and board. The couple's modified AGI is $137,250. Which of the following statements is true?

A portion of the interest is taxable, and a portion of the interest is tax-free.

All of the interest is tax-free.

All of the interest is taxable.

Answer 1

The statement "A portion of the interest is taxable, and a portion of the interest is tax-free" is true

Explanation-

1) The Interest portion of the EE savings bond is eligible for exclusion totally only in case that the entire cashed bond value(including principle and interest portion together) is utilized for the purpose of qualifying expenditure.

2) Suppose if the qualifying expenditure is less then the cashed amount of bond(principal+interest), then the interest exclusion from tax is done on pro-rata. which means only some portion of interest would be eligible for tax exclusion.

Formula = (qualifying expenditure/cash from bond)*interest

3) The qualifying expenditure includes the tuition amount but specifically excludes the room and board expenses.

So, in the given case, the cash from bond(principal+interest) = $10,000

The qualifying expenditure as per the point 3 discussed above = $7,000

so the qualifying expenditure is lesser than the cash from bond which leads to pro-rata tax exclusion of interest.

interest excluded for tax as per the formula in point 2 above = (7000/10000)*4800 = 3,360

so only the $3,360 portion of the interest is considered for tax-free calculation and remaining $1,440 is taxable.

Important Note : The couple would be eligible for tax exclusion only if they are married and filing jointly and they are having Modified Adjusted Gross Income(AGI) less than $149,300 (as per latest form 8815 release by IRS).

so as we can see the modified AGI of couple is $137,250 which is less than $149,300 hence they are eligible for tax exclusion of interest on Savings bonds.

Please note that the exact exclusion amount of interest is calculated on further methods by using other limits and calculations. the answer 3360 is further considered for calculation final amount of exclusion of interest.

As the question asked is whether the taxable or tax free. so the final exclusion amount calculation is not done. concentrated totally on taxability issue